ChinaOutlook120103 PDF (Daiwa)

China 3 January 2012
Back to 2008?
A Lehman-type crisis in Europe would likely spark a repeat of 2008-09 for China's economy - but on a smaller scale 2012 GDP growth likely to be slowest in a decade, but the equity market risk/reward outlook is good Favour industries that have moved on from the global financial crisis in terms of consolidation and other sectoral changes
2012 Outlook for China
Important disclosures, including any required research certifications, are provided on the last two pages of this report.

3 January 2012
Table of contents
Sector rating Economy 2012 Outlook for China: Back to 2008? China Market Strategy Automobiles Aviation Banks Cement Consumer Expressways Gaming and Leisure Heavy Machinery Infrastructure Insurance Oil and Gas Power and Power Equipment Property Solar Steel Telecommunications Thermal Coal Positive Neutral Positive Positive Neutral Positive Negative Neutral Positive Neutral Neutral Positive Neutral Neutral Neutral Positive
Analyst Mingchun Sun Kevin Lai Fei Xue Colin Bradbury Jeff Chung Kelvin Lau Grace Wu Queenie Poon Felix Lam Matthew Marsden Bing Zhou Kelvin Lau Gavin Ho Joseph Ho Winston Cao Edwin Lee Jennifer Law Adrian Loh Dave Dai Danny Bao Pranab Kumar Sarmah Alexander Latzer Alan Kam Alicia Hu Felix Lam
Page 3
Strategy Sector
10 23 27 31 35 39 43 47 51 54 57 61 65 69 73 76 80 83
Note: closing share prices as at 19 December 2011

3 January 2012
Back to 2008? We dont think so

Should a Lehman-type crisis occur in Europe, a repeat of 2008-09 would be likely for Chinas economy but on a smaller scale Policymakers seem better prepared for such a crisis now than in 2008, making China a likely safe haven in 2012 The economy is in the midst of a multi-year economic downturn; annual GDP growth should hit its lowest level in a decade in 2012 From a market perspective, the 2012 risk/reward outlook is good. Valuation of the MSCI China Index is now at a significant (33%) discount to its own long-term average We expect the China equity market to provide positive returns in 2012, though something of a trading mentality will be needed as the first half at least is likely to be a volatile time At the sector level, we compare and contrast what happened in 2008-09 with the situation now and the prospects for 2012. Our thematic picks are the stocks that we believe are best placed for 2012, again with reference to what happened in 2008-09. We favour industries that have moved on since the global financial crisis in terms of consolidation or other sectoral changes (eg, cement, autos and, to a more limited extent, property), or that emerged unscathed from the crisis and have evolved since then (eg, banks) We are more cautious on industries where little has changed in terms of unfavourable industry structure and lack of consolidation (eg, steel, metals), or where regulatory regimes mean returns are volatile and generally low (eg, IPPs)
Sector ratings and stock picks
Sectors Automobiles Aviation Banks Cement Consumer Expressways Gaming and Leisure Heavy Machinery IPP Infrastructure Insurance Oil & Gas Power Equipment Property Solar Steel Telecommunications Thermal Coal
Ratings Positive Neutral Positive Positive NR Neutral Positive Negative Neutral Neutral Positive Neutral Positive Positive Neutral Neutral Neutral Positive
Stock picks Dongfeng Motor, Great Wall Motor Air China ICBC CR Cement Li & Fung Yuexiu Transport Galaxy, Sands China Zoomlion CR Power China Comm. Cons. CPIC CNOOC Shanghai Electric, Harbin Electric Evergrande GCL Poly Baosteel China Telecom China Shenhua
Tickers 489 HK, 2333 HK 753 HK 1398 HK 1313 HK 494 HK 1052 HK 27 HK, 1928 HK 1157 HK 836 HK 1800 HK 2601 HK 883 HK 2727 HK, 1133 HK 3333 HK 3800 HK 600019 CH 728 HK 1088 HK
Ratings 1 (Buy), 1 (Buy) 1 (Buy) 2 (Outperform) 1 (Buy) 1 (Buy) 1 (Buy) 1 (Buy), 1 (Buy) 3 (Hold) 1 (Buy) 1 (Buy) 1 (Buy) 1 (Buy) 1 (Buy), 1 (Buy) 1 (Buy) 1 (Buy) 2 (Outperform) 2 (Outperform) 1 (Buy)
Source: Daiwa; note: prices as of close on 19 December 2011
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3 January 2012
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3 January 2012
What happened in 2008?
2012 Outlook for China: Back to 2008?

Mingchun Sun (852) 2773 8751 (mingchun.sun@hk.daiwacm.com) Kevin Lai (852) 2848 4926 (kevin.lai@hk.daiwacm.com) Fei Xue (852) 2773 8767 (fei.xue@hk.daiwacm.com) With the global economy threatened by the European sovereign debt crisis and China's economy on a downtrend as a result of policy tightening, many investors are wondering whether we are going to see a redux of 2008-09 in 2012. In particular, should an acute financial crisis occur in Europe, would it push China to an economic hard-landing (as we saw in 2H08)? If that were to happen, would the PRC Government introduce another stimulus package (as we saw in November 2008) and engineer a V-shaped recovery in 2012 (as happened in 2009)? In this report, we compare Chinas economy today with that in 2008-09. The comparison suggests that the current situation resembles that of 3Q08, when the government fine-tuned its tightening policies in response to various signs of economic trouble. The 50bps cut in the RRR on 30 November 2011 officially opened the gate for more policy loosening over the coming months. However, it is worth noting that the magnitude of the loosening in 3Q08 proved insufficient to forestall an economic hard-landing when the sudden collapse of Lehman Brothers in September 2008 dragged the whole world into a financial crisis and deep economic recession. As the situation in Europe remains uncertain and precarious, Chinas economy is still subject to significant external risks in the event of a Lehman-type acute crisis somewhere in the world. For that reason, our 2012 economic outlook for China hinges largely on developments in Europe. Even in a more benign scenario, the economy is likely to register its lowest growth rate in a decade, but with less volatility in quarterly growth patterns than in 2008-09.
China's economy looked overheated at the beginning of 2008. Real GDP growth was 11.3% YoY for 1Q08, while a once-in-50-year severe snowstorm in southern China pushed CPI inflation to an 11-year-high of 8.7% YoY in February 2008. Globally, commodity prices performed strongly in 2007 and through into 1H08, encouraging producers to hoard raw materials, either for hedging or speculation. Strong economic growth also encouraged producers to increase their finished goods inventory, causing a big gap between final demand and aggregate demand (or GDP) growth, which exaggerated GDP growth.
GDP and final demand
(% YoY) 15 Inventory accumulation Forecast
12
9 Destocking 6
Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12
Final demand
Source: CEIC
Aggregate demand (GDP)
To cool down the red-hot economy, policymakers had been introducing aggressive tightening measures since late 2007, including a strict loan quota (Rmb3.6tn) for 2008. The impact started to be seen right after the Lunar New Year (in 2008) as property sales declined sharply and real-estate agencies shut down shops across the country. Meanwhile, exporters were hit with surging labour costs (due to changes in the labour law), raw-material costs and faster currency appreciation. Weakening demand and tight credit pushed many manufacturers to record losses. Some were caught up in the triangle debt chain, mainly in the form of accounts receivable and loan guarantees. In some places, the default of a few large manufacturers caused a sudden breakdown in the debt chain, forcing local governments to step in and rescue those companies in trouble.
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3 January 2012
Loss-making industrial enterprises

(YTD, % YoY) 200 150 100 50 0 (50) (% YoY) 30 20 10 0 (10) (20)
halt in production in many sectors, dragging down production growth sharply. Massive destocking exaggerated the decline in GDP growth in 2H08, creating a large negative gap between aggregate and final demand over 3Q08-4Q09 (see GDP and final demand chart on the previous page).
PMI inventory
(%) 54 52 50 48 46 44 42 40 38 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Raw-material inventory Expansion-contraction line
Source: CEIC
Sep-06
Sep-07
Sep-08
Sep-09
Sep-10
May-06
May-07
May-08
May-09
May-10
Amount of loss (LHS)

Source: CEIC, Daiwa
No of loss-making units (RHS)
By July 2008, the problems in the economy had become so obvious that, on 25 July, policymakers finetuned their policy tone from to fight against inflation and overheating to to fight against inflation and maintain economic growth. Favourable policies toward SMEs and exporters were introduced and the PBOC raised loan quotas by 5-10% for 2008.
May-11
Sep-11
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Finished-goods inventory
The stimulus
In the face of the sudden collapse in demand, Chinas policymakers reversed their tightening policies in October 2008. The PBOC cut policy interest rates by a total of 189bps and the RRR by a total of 225bps over three months. Most importantly, on 9 November 2008, the government announced a stimulus package amounting to Rmb4tn over 2009-10, together with more policies to boost property sales. Following the Rmb4tn stimulus package, the countrys economy, and property and stock markets all staged V-shaped recoveries in 2009, albeit at different paces.
The Lehman crisis

However, the magnitude of the policy loosening proved insufficient to stop the slide in the real economy, when the sudden collapse of Lehman Brothers on 15 September 2008 pushed Chinas economy into a nosedive. For example, export growth, which held up quite well at 21.7% YoY in September 2008, plunged to -2.2% YoY in November. The plunge was the combined result of synchronised global destocking, a sudden freeze in global trade financing, and a sudden disappearance in global demand due to the loss of consumer and business confidence around the world.
Export growth in value and volume terms
(% YoY, 3mma) 45 35 25 15 5 (5) (15) (25)
Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11
Where are we now?

Today, Chinas economy looks similar to that in 3Q08, just before the collapse of Lehman Brothers and after the government fine-tuned its tightening policies in response to various signs of economic trouble. Now that the countrys policymakers have loosened credit control and cut the RRR, it remains to be seen whether the loosening will be enough to avoid an economic hardlanding if Europe sees an acute, Lehman-type crisis.
Export value
Source: CEIC, Daiwa
Export volume
A self-engineered domestic slowdown

Chinas GDP growth has been on a smooth and stable downtrend over the past year, falling from 9.8% YoY in 4Q10 to 9.1% YoY in 3Q11. The slowdown was purely the result of policy tightening, as policymakers tried to rein in high CPI and property-price inflation. For example, the PBOC has hiked the RRR to the highest level in history (21.5% for large financial institutions) and raised policy interest rates by a total of 125bp since 3Q10. -4-
The collapse in external demand, as well as the sharp decline in commodity prices, triggered massive destocking, as reflected by the inventory components of the PMI. As companies tried to deplete stock levels before making new orders or products, there was a sudden loss of demand for raw materials and a sudden

3 January 2012
After more than a year of tightening, the real economy is starting to suffer. Daiwas China Momentum Gauge, which tracks 20 economic indicators and counts the number of them exceeding 12-month moving averages, fell to a very low level of 3 in November, showing the economy is on a very weak footing.
Daiwa China Momentum Gauge
No. of indicators above 12-month moving averages 20 18 16 14 12 10 8 6 4 2 0 Strong momentum (Index) 3,500 3,300 3,100 2,900 2,700 2,500 2,300 2,100 1,900
YoY in July to 20.1% YoY in November, reminding us of the situation in 2008, when property-investment growth fell from 37.5% YoY in June 2008 to 1% YoY in January 2009 (just seven months).
Real-estate investment
(% YoY) 40 35 30 25 20 15 10 5 0
Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 May-06 May-07 May-08 May-09 May-10 May-11 Sep-11 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
Weak momentum
Sep-09
Nov-09
Sep-10
Nov-10
Sep-11
May-09
May-10
May-11
Nov-11
Jul-09
Jul-10
Jan-09
Jan-10
Mar-09
Mar-10
Jan-11
Mar-11
Jul-11
Source: CEIC, Daiwa
Daiwa China Momentum Gauge (LHS) Shanghai stock exchange composite index (RHS)
Source: CEIC, Daiwa
In particular, infrastructure-investment growth fell sharply from 17.4% YoY in 2010 to only 5.4% YoY for the first 11 months of 2011, as regulators tightened bank lending to local government financing vehicles (LGFV). Considering the inflation factor, realinfrastructure fixed-asset investment (FAI) growth was actually negative, a situation much worse than in 2008.
FAI growth by sector
(YTD, % YoY) 50 40 30 20 10 0 2005 2006 Manufacturing
Source: CEIC, Daiwa
Developers thirst for funding has pushed up the countrys overall funding costs. In the manufacturing sector, many entrepreneurs are unable to repay their high interest-rate debt and some are choosing to flee the country or commit suicide, reminding us of similar stories in 2008. Fortunately, the breakdown in the debt chain seems to have been confined to the private lending market so far. But the triangle debt chains in the form of accounts receivable, which rose by 20.7% YoY among industrial enterprises in the first 10 months of 2011, remain a big risk to Chinas financial stability.
Industrial enterprise: accounts receivable (% YoY)
(YTD, % YoY) 30 25 20 15 10
2007
2008 Real estate
2009
Sep-06
Sep-07
Sep-08
Sep-09
Sep-10
May-06
May-07
May-08
May-09
May-10
Source: CEIC, Daiwa
Tightening policies have also reined in inflation. CPI inflation fell sharply to 4.2% YoY in November from the recent peak of 6.5% YoY in July, similar to the situation in 3Q08. Property sales fell sharply and many developers started to cut prices to boost sales and cash flow. Some developers in desperate need of liquidity were paying per-annum interest rates of 20-30% to private lenders or trust companies for loans. Those that cannot afford such high borrowing costs, or have no access to credit, will have to stop their investments or sell their projects at bargain prices. In fact, real-estate investment growth has dropped sharply, from 36.5% -5-
Not surprisingly, the SMEs have started to complain again about higher labour costs, raw-material costs, currency appreciation, and higher borrowing costs, exactly the same as in 2008. Similarly, both the number of loss-making industrial enterprises and the amount of losses have jumped in recent months. Domestic consumption growth has also weakened in real terms, with real retail sales growth of only 12.8% YoY in November, well below its average of 14.2% YoY since 2006.
May-11
Sep-11
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-Nov 2011 Infrastructure
2010

3 January 2012
Retail sales growth: nominal versus real

% YoY 24 20 16 12 8 4
What will happen in 2012?

As Chinas economy is faltering due to domestic monetary tightening, an acute global crisis could easily send it over the edge. Learning from the lessons in 2008, policymakers are likely to take a more proactive and forward-looking approach in 2012, stepping away from the cliff before the external shock arrives. Therefore, we expect more policy loosening in 1H12, although the overall policy stance should remain prudent throughout 2012 due to long-term constraints. It remains to be seen whether the loosening will be sufficient to forestall an economic hard-landing in the event of an acute global crisis.
Sep-06
Sep-07
Sep-08
Sep-09
Sep-10
May-06
May-07
May-08
May-09
May-10
Nominal retail sales

Source: CEIC
Real retail sales
Exports: about to nosedive?

Export growth fell from a peak of 48.5% YoY in May 2010 to just 13.8% YoY in November 2011. While the current pace of growth is still in double digits, the forward-looking export-order component of the PMI points to further downside. It remains to be seen whether an acute, Lehman-type crisis will result in a nosedive in Chinas exports, similar to the situation in 2008 after the Lehman bankruptcy.
Official PMI and its export-order component
(%) 65 60 55 50 45 40 35 30 Jan-05
Source: CEIC
May-11
Sep-11
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
GDP growth
In the absence of an acute crisis in Europe, Chinas GDP growth should range between 8.0-9.0% YoY throughout 2012: we forecast it to average 8.3% YoY for the full year. Growth should be higher in 2H than in 1H as the lagged effects of policy loosening start to show up. Should there be an acute crisis in Europe, economies globally, including Chinas, would be hit hard, as was the case in 2008. In this case, the decline in GDP growth would be much sharper. However, due to the fundamental differences between Chinas economy today and in 2008, the decline would not be as sharp as in 2H08-1H09, in our view. We would expect real GDP growth to remain above 7.0% YoY in 2012, even in the event of an acute global crisis. The sharp decline in China's GDP growth in 2008-09 was exaggerated by massive destocking from 2H08, as there had been massive inventory accumulation before that. But this time, judging by the chart on page 3 (GDP and final demand), inventory accumulation has been much less pronounced over the past year, allowing for much less destocking. Hence, destocking is unlikely to result in much volatility in GDP growth in 2012. Our estimate suggests that final demand growth, at 8.7% YoY in 3Q11, is already the weakest since 4Q02. While we expect demand growth to dip further in the coming quarters, it is likely to be cushioned by robust consumption and flexible policies towards investment. Despite further economic weakening, consumption growth should remain robust in 2012 as it has always been the most stable contributor to GDP growth in China. Massive household savings, as evidenced by Rmb33tn (or 83% of GDP) in household deposits in the banks as at the end of November 2011, should serve as a cushion for household consumption. -6-
Jan-06 PMI
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11 PMI: Export orders
Expansion-contraction line
Policy fine-tuning
Similar to the responses in July 2008, Chinas policymakers have been fine-tuning their policies since October 2011 to avoid an economic hard-landing. The State Council has announced new policy measures to support SMEs through increased lending facilities and lower taxes and fees, similar to the policy initiatives undertaken in July 2008. The PBOC also cut the RRR by 50bps in a surprising move on 30 November 2011, opening the gate for more loosening measures in the coming months.

3 January 2012
GDP contribution by component

(pp) 15 12 9 6 3 0 (3)
CPI inflation
CPI inflation has been falling sharply towards the end of 2011. We forecast it to fall further, to 3.3% YoY for 2012, from 5.4% YoY for 2011, mainly due to a high base effect. However, the chances of deflation as we saw in 2009 are very low. The current inflation cycle is more complex than the one in 2007-08, which was mainly driven by supply shocks (pork and vegetables). The current cycle is a combined result of rapid rises in labour costs, imported inflation, high inflation expectations, and temporary supply shortages of certain food items (vegetables and pork, again). As food shortages have been relatively short-lived and less severe this time than in 2007-08, changes in food prices have been less volatile in this cycle. Hence, we do not expect food CPI to experience deflation this time. Meanwhile, non-food CPI inflation should prove to be stickier in 2012, as rising labour and other input costs are likely to be more structural than cyclical in the coming years.
Food prices the main driver of inflation
(YoY %) 24 21 18 15 12 9 6 3 0 (3)
Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11
2011E
2012E
2013E
2014E
Consumption
Source: CEIC, Daiwa forecasts
Investment
Net exports
While we also expect investment growth to fall further, it is unlikely to collapse because it is more easily influenced by government policies. In the event of a sharp decline in private property investment caused by a liquidity crunch among developers, the central government would likely adjust its policy quickly and allow more funding for LGFVs (to boost infrastructure investment) and public-housing projects. It might also relax tightening measures on the property market to boost private investment in the housing sector. In addition, exports are unlikely to fall as sharply in 2012 as in 2009, even in the event of an acute global crisis. The sharp decline (-16% YoY) in China's exports in 2009 was caused by massive and synchronised global destocking, which, in turn, was a consequence of massive inventory accumulation over 2004-08. But today, both the US and Japan have significantly reduced inventory levels, suggesting less pressure for destocking in the event of an acute crisis. The only risky area is the EU, where inventory levels are above 2008 levels. But overall, the magnitude of a global trade freeze would be smaller in 2012 than in 2009, in our view.
Cumulative changes in inventory levels: the US, EU, and Japan
(US$bn) 700 600 500 400 300 200 100 0
2015E
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Overall
Source: CEIC
Food
Non-food
Property market
On the eve of the Lehman bankruptcy in 2008, hundreds of China developers were on the verge of bankruptcy. Fortunately, the PRC Government reversed its policy on the property market after the bankruptcy of Lehman, bringing those developers back to life. As a result, the national average residential property price declined by only 7-8% from peak to trough in 2008-09. Learning from the lessons in 2008, most developers are better prepared this time to survive the tightening cycle, which made the tightening policies almost ineffective until 3Q11. As the market has just started to cool, it seems too early for the government to loosen its policy over the near term, even though property prices in some cities have fallen sharply in recent months. We expect property prices and transaction volumes to continue to decline until the middle of 2012. -7-
US
Source: CEIC, Daiwa
EU 27
Japan
3Q11
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010

3 January 2012
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Ratios of property investment to GDP and FAI

(%) 30 25 20 15 10 5 2004 2005 2006 2007 2008 2009 2010 1-3Q2011 as % of total FAI
Source: CEIC Source: CEIC
1-year deposit rate, % p.a.
CPI inflation, % YoY
On the other hand, Chinas policymakers are likely to react swiftly and forcefully on the fiscal-policy front should there be an acute global crisis. Similar to what happened in late-2008, they are likely to introduce tax subsidies to boost consumption, with automobiles and household electrical appliances at the top of their list. While we do not expect the government to introduce another investment stimulus, we do expect regulators to be more flexible in their policies toward bank loans to LGFVs and the Ministry of Railways. It is likely to give a higher priority to ongoing infrastructure projects to avoid a collapse in infrastructure investment and a surge in non-performing loans (NPL) due to a sudden credit freeze to these entities. Beyond that, intra-city infrastructure projects (such as subways and light railways) may also be given higher priority for funding and approval. There could be more upside on the policy front in 2012. For example, the government may come up with a solution to LGFV financing, both for existing loans and new borrowing, which should alleviate some of the burden on banks as the central and local governments are most likely to take on more financial responsibility than at present. The financial regulators may also consider allowing the banks to securitise certain types of loan (mortgages or LGFV loans), which, through the freeing-up of the capital requirement and the lowering of loan-to-deposit ratios (LDR), will enable the banks to increase lending capacity.
as % of GDP
Policy
As CPI inflation has fallen sharply and economic growth has slowed notably as we approached the end of 2011, there is room for more policy easing in 1H12. The 50bp RRR cut on 30 November 2011 was just the beginning, in our view, and we expect a further 200bps in cuts in 1H12, similar to the aggressive RRR cuts in 4Q08. We expect the PBOC to set the M2 growth target at 14-15% YoY for 2012, higher than the actual 12.7% YoY for November 2011. This means that overall credit conditions are likely to be looser in 2012 than in 2011, with new bank loans possibly exceeding Rmb8.5tn (compared with Rmb7.5tn for 2011E). However, as negative real interest rates are unlikely to disappear until 2Q12, and CPI inflation should rebound in 4Q12 due to the base effect, we see no interest-rate cuts in 2012, even in the event of an acute crisis globally (unlike in 4Q08 when the PBOC cut interest rates by a total of 189bps).
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Jan-12
As property prices continue to fall and property investment continues to weaken, we expect policymakers to change their focus and start to loosen policies on the property sector gradually and without fanfare as early as 2Q12, given the importance of the property sector to employment, fiscal revenue, financial sector stability, and investment. However, a 180-degree reversal in the current tightening policy seems unlikely in 2012, in our view, as policymakers cannot afford another property-price bubble in the coming years.
CPI inflation and one-year bank deposit rates

(%) 10 8 6 4 2 0 (2) Estimate

3 January 2012
That said, we need to point out that any policy loosening in 1H12 would only be temporary and limited. We are unlikely to see the type of aggressive policy loosening or massive stimulus packages we saw in 2008-09. On the contrary, to pay back for the surge in investment and money supply growth in 2009-10, and to reduce the risk of creating an even bigger investment and asset-price bubble during 2012-15, policymakers are likely to stick to a prudent monetary and investment policy in the coming years (see China economy: Walking a tightrope, published on 6 July 2011). Such policy efforts resemble those during 200408, when the PBOC tried to withdraw excess liquidity from the economy for five years in a row.
Excess liquidity
(%) 20 16 12 8 4 0 (4) (8)
Conclusion
In summary, we see a redux of 2008-09 if an acute global crisis were to occur in 2012, but the scale of the economic swing would probably be smaller. Even if policymakers were not willing to react aggressively to the crisis, they would still have sufficient ammunition to forestall an economic hard-landing, if needed. This ability would make China one of the worlds safe havens if an acute crisis were to occur in 2012. On the other hand, if there were no such crisis, we would expect further policy loosening in 1H12, and a return to a prudent (ie, neutral) policy stance in 2H12. As a result, we would not expect a significant rebound in GDP growth, investment growth, or money supply growth following the loosening. Instead, we expect all these indicators to continue their multi-year declines, with real GDP registering the lowest year-on-yeargrowth in a decade for 2012. Along this path, the economy, as well as the household, corporate and financial sectors, would have to go through painful structural transformations, providing both challenges and opportunities for China investors.
Annual real GDP growth: 1981-2015
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011E 2012E 2013E
(% YoY) 16 14 12 10 8 6 4 2
6 years
7 years
8 years
Source: CEIC
2011E
2013E
China: main macroeconomic indicators

Real GDP CPI PPI FAI (nominal, YTD) Retail sales (nominal) Industrial production Exports Imports Trade balance Exchange rate M2 One-year base lending rate One-year deposit rate Required reserve ratio Current-account balance Foreign reserves Fiscal balance
YoY % YoY % YoY % YoY % YoY % YoY % YoY % YoY % US$bn Rmb/US$ YoY % % pa % pa % % of GDP US$tn % of GDP
1Q11 9.7 5.1 7.1 25.0 16.3 14.9 26.4 32.9 (2.1) 6.56 16.6 6.06 3.00 19.5 3.0
2Q11 9.5 5.7 6.9 25.6 17.2 13.9 22.1 23.1 46.5 6.47 15.9 6.31 3.25 21.0 3.2
3Q11 9.1 6.3 7.1 24.9 17.3 13.8 20.6 24.9 62.6 6.35 13.0 6.56 3.50 21.0 3.2
4Q11E 8.5 4.6 3.1 24.0 17.5 12.5 11.4 19.5 37.7 6.35 13.0 6.56 3.50 20.5 3.2
1Q12E 8.0 4.3 1.0 21.8 15.8 11.3 4.9 7.5 (12.8) 6.30 14.2 6.56 3.50 19.5 3.2
2Q12E 8.2 3.0 1.2 19.5 16.4 11.8 9.3 12.4 37.8 6.25 14.5 6.56 3.50 18.5 3.3
3Q12E 8.4 2.6 2.0 18.0 15.8 12.4 5.3 7.0 58.5 6.20 14.5 6.56 3.50 18.5 3.4
4Q12E 8.7 3.4 3.6 17.0 16.7 12.8 8.3 10.1 33.0 6.15 14.0 6.56 3.50 18.5 3.5
2011E 9.2 5.4 6.1 24.0 17.1 13.8 19.5 24.7 145 6.35 13.0 6.56 3.50 20.5 3.0 3.2 (2.0)
2012E 8.3 3.3 2.0 17.0 16.2 12.1 7.0 9.2 116 6.15 14.0 6.56 3.50 18.5 2.5 3.5 (2.5)
2013E 7.5 4.0 4.5 15.0 17.0 11.5 12.0 15.0 76 5.90 12.0 7.06 4.00 18.5 2.0 3.8 (2.0)
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2015E
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3 January 2012
China Market Strategy

Colin Bradbury (852) 2848 4983 (colin.bradbury@hk.daiwacm.com)
financial crisis was in 4Q07, with the final climactic selloff taking place in October 2008. In the current crisis, the index peaked in 4Q10 and the sharpest sell-off (MSCI China -33%) was in an eight-week period, with the index bottoming at the end of October 2011.
MSCI China Index: global financial crisis and sovereign debt crises compared
(Rebased to 100) 120 100
2012 risk/reward outlook is good

It was a pretty miserable year for Chinese equities in 2011. Having managed a 7% YTD gain by late April 2011, the subsequent decline has left the MSCI China Index 22% below its end-2010 level. The net result of this is that, as the chart below shows, the MSCI China Index is at almost exactly the same level as it was at the end of 2006; the market has basically spent the past five years going nowhere, albeit the flat market disguises two significant bull and bear markets.
MSCI China Index: January 2007 to date (rebased to 100)
(Rebased: 1/1/2007 = 100) 220 200 180 160 140 120 100 80 60 40 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11
Source: MSCI
80 60 40 20 0 10 20 30 40 50 60 70 (Weeks) Lehman collapse
MSCI China - Start date: 2 Nov 2007

Source: Bloomberg
MSCI China - Start date: 5 Nov 2010
For what it is worth, as the preceding chart shows, in terms of the numbers of weeks from peak to trough, we have now passed the point at which the market bottomed in the global financial crisis. This leads to the big question of the moment: does the trough which followed the August to October 2011 plunge represent the low for this bear market?
What are valuations telling us?

We start, inevitably, with the question of whether equity valuations suggest we have reached a turning point. Investors are doubtless bored of the market is cheap story, so lets get it out of the way first.
MSCI China Index: valuation cycles (forward PER since 2003)
(x) 30 25 20 15 10 5 0 -1 SD +1 SD
The overall theme of this report is a look back to the experience of 2008 as a means of getting some perspective on how investors are likely to fare in 2012. From a macroeconomic and a company perspective there are clear parallels, but also significant differences, between the experience of the global financial crisis and the present situation; this applies equally to the outlook for the equity market as a whole. The good news, against the backdrop of a disappointing year so far, is that there are some reasons to be optimistic. If 2010-11 proves to be the equivalent of 2007-08, investors will be heading into a very rewarding 2012 since the MSCI China index rose by almost 59% in 2009. At the risk of stretching a point, it is also interesting (though maybe no more than that) to note the comparisons with 2007-08 in terms of the length of the bear market. The China market peak during the global
May 04 Dec 05 20-M
Dec 05 - Nov 07 24-M
Nov 07 - Oct 08 - Aug 09 Oct 08 Aug 09 now 12-M 10-M 28-M
Jul-03
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12-month forward PER

Source: MSCI, IBES
As the preceding chart shows, the 12-month forward PER, at 8.3x now, remains well below the long-term normal range (10-15x), and the current PER down-cycle is the longest period of trending valuations in recent history.
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Jan-11
Jul-11

3 January 2012
Taking a longer-term perspective, the next chart shows what has happened to the core fundamentals (ie, earnings) over the past few years relative to share prices.
MSCI China Index and earnings have converged again
(Rebased Jan 2003 = 100) 8 7 6 5 4 3 2 1 0
MSCI China Index: PER vs. MSCI Asia ex-Japan Index

50 40 30 20 10 0 (10) (20) (30)
19%
Jul-03
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
Jul-09
Jul-10 Jul-10
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
12m fwd PER relative to MSCI ASJ

Source: MSCI, IBES
Average 0.9%
Jul-03
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
Jul-09
Jul-10
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
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Jan-09
Jan-10
Jan-11
Jul-11
MSCI China Index

Source: MSCI, IBES
12-month trailing EPS
The good news is that equity prices have now in aggregate fallen back to the underlying earnings support line as they did in late 2008/early 2009. Again, this in itself does not prove that the market has bottomed, but it at least highlights the fact that there is no stimulus-related optimism left in Chinese equity prices. This means that the valuation of the MSCI China Index is now at a significant (33%) discount to its own longterm average.
MSCI China Index: PER relative to average (since 2003)
100 80 60 40 20 0 (20) (40) (60)
Finally, despite that most of the problems weighing on global equities originate from the developed world, China is now also at a significant discount to the European and US markets in forward PER terms.
MSCI China Index: forward PER relative to S&P and STOXX 600
120 100 80 60 40 20 0 (20) (40) (60)
Jul-03
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
Jul-09
Jan-11 Jan-11
Jul-11
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Relative to S&P 500

Source: MSCI, IBES
Relative to STOXX 600
32.7%
Jul-03
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
Jul-09
Jul-10
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
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Jan-03
Jul-11
Moreover, this cannot be explained by a decline in corporate profitability, as the rock-bottom PBR (1.4x compared with a 2.0x historical average) of Chinese stocks seems unreasonable to us in light of its average ROE, which is closer to the top end of the historical range.
MSCI China Index: PBR and ROE
(%) 18 17 16 15 14 13 12 (X) 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
12-month forward PER relative to long-term average

Source: MSCI, IBES
Average 12.5x
The MSCI China Index is also at a record (19%) discount to the MSCI Asia ex Japan Index in forward PER terms.
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
Jul-09
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jul-10
Jan-10
Jan-03
ROE
Source: MSCI, IBES
PBR (RHS)
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Jan-11
Jul-11
Jul-11

3 January 2012
So it is clear that in terms of the raw numbers, equity valuations in China are firmly at the bottom end of the historical range. The question then is why, in spite of that, might we not yet have seen the bear market low?
China GDP: peak-to-trough change (YoY %)

Global financial crisis 2Q07 14.8 1Q10 11.9 2Q08 10.8 3Q11 9.1 1Q09 6.6 1Q12E 8.0
Now
Source: Bloomberg, Daiwa forecasts
Why might we not yet have hit the bottom?

There are two factors that might prevent these apparently cheap valuations from becoming the launch pad for a new bull market. Either: 1. because the market is not really as cheap as it looks as earnings are going to fall short of expectations, or 2. because there are other factors that will keep valuations at depressed levels. This is where comparisons with the 2007-08 global financial crisis become highly relevant.
As the table shows, the year-on-year GDP growth rate fell by 400bps in just four quarters in 2007/08 and then by a further 420bps in the subsequent three quarters (a total of 820bps in seven quarters). In the present cycle, by contrast, we forecast that GDP growth will have slowed by just 390bps with the peak-totrough spread over eight quarters. In addition, pressure from high commodity prices is much less of a factor in the current cycle. The commodity price spike which took the CRB index up more than 50% from the beginning 2007 level did not peak until July 2008, inflicting severe margin damage on companies already dealing with faltering end demand. In this cycle, while the index rose by around 48% from its mid-2010 low, it peaked in May this year and has since given up half the gains. It is a similar story with oil, with the WTI crude price now 16% above the beginning 2010 level compared with the 134% jump from the beginning of 2007 to its July 2008 peak. The next table shows operating-profit margin trends for stocks in the MSCI China Index around the global financial crisis.
MSCI China: operating-profit margins (%)
MSCI China Sectors Energy Materials Industrials Consumer Discretionary Consumer Staples Financials IT Telecom Services Utilities Industry Groups Oil & Gas & Coal Chemicals Construction Materials Metals & Mining Construction & Engineering Airlines Marine IPPs
Source: MSCI, FactSet
Earnings risks: is China as cheap as it looks?

The most common concern when addressing valuations is whether the cyclical economic downturn means we are heading for big earnings forecast cuts. History tells us that we are right to be concerned, as there is a clear relationship between headline economic growth and the performance of the corporate sector at the EBITDA and net profit levels.
China: nominal GDP growth and corporate profits
(YoY%) 60 40 20 0 (20) 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011E 2012E Hong Kong listed China stocks Net Income YoY% growth (LHS) Hong Kong listed China stocks EBITDA YoY% growth (LHS) Nominal GDP YoY% growth (RHS)
Source: IBES, CEIC, Daiwa forecasts
(YoY%) 25 20 15 10 5 0
2006 19.3 17.0 15.1 7.4 16.0 10.2 33.9 2.0 24.4 21.1 17.0 2.1 19.3 20.1 (3.9) 10.6 20.1
2007 19.3 16.1 12.6 8.1 10.6 9.3 37.4 3.4 22.7 19.4 16.1 4.3 18.7 14.8 4.0 (0.6) 18.1 18.5
2008 14.3 11.6 4.6 4.8 7.2 9.8 29.7 4.2 20.5 5.4 11.5 (2.1) 14.6 5.4 1.9 (8.5) 11.0 3.4
2009 15.7 13.7 6.5 2.2 8.8 12.4 34.4 7.4 17.0 16.1 13.6 3.1 16.2 4.9 1.9 (1.2) (15.9) 14.8
However, it should be noted that the downturn in 201112 looks set to be less severe; we expect a cycle low for Chinas nominal GDP growth of 12.0% YoY in 2012, compared with 8.6% YoY in 2009. Moreover, in 2008-09 it was the combination of the speed and magnitude of the economic slowdown that inflicted the damage on the corporate sector.
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3 January 2012
Operating-profit margins for the universe as a whole dropped sharply, from 19.3% in 2007 to 14.3% in 2008. We have broken out a few key industry groups to show the impact on the sector-level margin trends of high raw material input costs. Highlights are the Energy Sector, driven by oil and coal (the sector is vulnerable to higher oil prices due to its exposure to downstream refining losses in an environment of controlled product prices), materials, which is driven by chemicals, construction materials (including cement) and metals and mining (including steel, which was hit by higher iron ore and coal prices in 2008). Higher oil prices (and declining demand) decimated margins in the airlines and marine sectors, while dramatically higher coal prices saw margins at the IPPs collapse as tariff controls prevented them from passing on increased costs to the consumer. This illustrates how a number of deep cyclical industries were hit very hard in a short space of time in 2008. It was the sharp profit decline, and in some cases the slide into losses, in these sectors that dragged down the overall market earnings aggregate in that year (aggregate EPS for the MSCI China Index fell by 10.9% YoY).
MSCI China: sector earnings growth in 2008 global financial crisis (YoY %)
China Energy Equipment Oil Gas & Fuels Chemicals Construction Materials Metals & Mining Paper & Forest Products Construction & Engineering Electrical Equipment Industrial Conglomerates Machinery Airlines Marine Transportation Infrastructure Automobiles Textiles Apparel & Luxury Multiline Retail Specialty Retail Beverages Food Products Personal Products HealthCare Equipment Commercial Banks Diversified Financial Services Insurance Real Estate Management & Development Internet Software & Services Communications Equipment Computers & Peripherals Electrical Equipment Instruments Diversified Telecoms Wireless Telecoms Gas Utilities Water Utilities IPPs
Source: MSCI, IBES
As the preceding table shows, earnings growth for the airlines, chemicals, industrial conglomerates and IPP sectors went into the red in 2008. The metals and mining, marine, speciality retail, diversified financial services and computer sectors remained in the black but registered sharp profit declines. However, these sectors individually accounted for a smaller percentage of the MSCI Chinas market capitalisation than the larger sectors, such as banks and telecoms, which were relatively unaffected by the global financial crisis. The only large-cap sector that registered a big earnings drop was insurance, owing to its exposure to the domestic A-share market. Since we believe the current economic downturn is likely to be less severe than the previous one, it is difficult to see a scenario that would generate big earnings risks in 2012; the potential for severe disruption to the corporate sector appears to be smaller this time around. Nevertheless, earnings forecasts have been creeping lower for some months now and we would expect this to continue as we go into 2012. IBES consensus numbers for this year and next have been trimmed steadily since September, as the next table shows.
Changes in 2011 and 2012 MSCI China Index earnings forecasts
Current EPS integer Sep-2011 EPS integer Change (%)
Source: IBES
(10.9) 27.3 0.8 (126.6) 20.0 (57.5) (9.3) (12.9) (20.7) (158.9) (20.1) (319.1) (40.8) (25.5) 24.7 50.6 41.4 (55.3) 36.7 14.0 27.1 64.8 34.6 (75.3) (57.3) (9.0) 73.2 73.6 (149.1) (27.1) (2.3) 29.4 21.8 9.6 (106.5)
2011E 5.76 5.90 (2.3)
2012E 6.39 6.73 (5.0)
History tells us that there is a pattern to consensus earnings forecasts in a downturn. The revisions ratio (which tracks the number of stocks with upward revisions minus the number with downward revisions as a percentage of the total forecast universe) tends to track the market, ie, analysts start to adjust forecasts in line with the direction of the index. As the revisions ratio simply tells us that forecasts have been changed and does not take account of the size of the revisions or the market capitalisation of the companies affected, there is no consistent or even immediate impact on the aggregate market earnings forecast. So a large number of relatively small revisions in one direction may not have much impact on the overall market earnings forecast. However, a change in the revisions ratio does tend to be followed, with a lag, by changes in the aggregate numbers; once the trend in the revisions ratio changes direction, the size of the revisions tends to increase. We saw this during the global financial crisis, as the revisions ratio rolled over with the market in 4Q07 but the forecast 2008 and 2009 market earnings integer only started to decline in mid-2008.
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3 January 2012
MSCI China Index: earnings revisions ratio, 2008 and 2009

110 100 90 80 70 60 50 40 30
Jul-07 Jul-08 Jan-08 May-07 Jan-09 May-09 May-08 Mar-07 Mar-08 Mar-09 Jul-09 Sep-09 Nov-07 Sep-07 Nov-08 Sep-08 Nov-09
30% 20% 10% 0% -10% -20% -30% -40%
MSCI China Index: 2011 and 2012 earnings revisions ratio and EPS forecasts
7.0 6.5 6.0 5.5 5.0 4.5
Sep-09 Nov-09 Nov-10 May-09 May-10 May-11 Nov-11 Sep-10 Sep-11 Jul-10 Jul-09 Jan-10 Mar-09 Mar-10 Jan-11 Mar-11 Jul-11
20% 15% 10% 5% 0% -5% -10% -15% -20% -25%
MSCI China index (LHS)

Source: MSCI, IBES
2008
2009
2011 EPS (LHS)

Source: MSCI, IBES
2012 EPS (LHS)
2011
2012
MSCI China Index: 2007-09 earnings revisions ratio and EPS forecasts
5.5 5.0 4.5 4.0 3.5 3.0
Jul-07 Jul-08 Jan-08 May-07 Jan-09 May-09 May-08 Mar-07 Mar-08 Nov-07 Sep-07 Nov-08 Mar-09 Jul-09 Nov-09 Sep-08 Sep-09
30% 20% 10% 0% -10% -20% -30% -40%
So far, then, this is consistent with a more moderate downturn in earnings growth compared with the global financial crisis, but we would not be surprised to see the consensus MSCI China Index earnings forecast for 2012 slipping into single digits before too long. The flip side of the less dramatic earnings slowdown is that we are not going to see a repeat of 2009s stimulus-driven earnings rebound. From a global perspective, the very nature of the current crisis, centred as it is on government deficits, precludes the type of fiscal response that pulled the worlds economies back from the abyss in 2009. In addition, with several rounds of quantitative easing behind us and interest rates at rock bottom in the biggest economies, the monetary bullets have been largely used up. The fiscal restraint issue is clearly highly relevant to China, since it was here in 2009 that we saw the most dramatic fiscal package of all. We are clearly in for a prolonged period of much less racy, but ultimately more sustainable, economic policies in China. We believe there will be no repeat of the fiscal and monetary binge of 2009, which was the near-panic response to the collapse in Chinas export markets in the wake of the global financial crisis. The areas for debate around the outlook for the China market in 2012 are relatively clear.
2008 EPS (LHS)

Source: MSCI, IBES
2009 EPS (LHS)
2008
2009
Turning to the current revision trends, we see that the revisions ratio turned down in 4Q10 and moved into negative territory in 3Q11 as the equity market rolled over. The ratio for 2012 Index earnings has fallen into the -15% to -20% range, which is obviously a significant decline, albeit still above the -30% to -40% range at which it bottomed in late 2008.
MSCI China Index: 2011E and 2012E revisions ratio
75 70 65 60 55 50 45 40 35 30
Sep-09 Nov-09 Nov-10 Sep-10 Sep-11 May-09 May-11 May-10 Nov-11 Jul-09 Jul-10 Jan-09 Jan-10 Mar-09 Mar-10 Jan-11 Mar-11 Jul-11
20% 15% 10% 5% 0% -5% -10% -15% -20% -25%
Structural risks: is it different this time?

So much for the cyclical earnings-related factors. The other issue that could cause investors to shy away from apparently cheap Chinese equities would be some form of looming structural/systemic problem. If this were of a game changing nature it could negate any view of valuations based on recent historical precedents.
MSCI China index (LHS)

Source: MSCI, IBES
2011
2012
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3 January 2012
These types of concerns were at their height in the middle of 2011, with a range of near-Doomsday scenarios being rolled out. These included fears of a rash of LGFV defaults, a collapse in the property market, a big increase in bank NPLs as a result of both of those factors, and a systemic crisis in the so-called shadow banking system. In addition, allegations by Muddy Waters and others of financial wrongdoing at a number of companies led some international investors to conclude that the numbers in China, whether on corporate financial statements or emanating from government departments, just couldnt be trusted. Returning to our theme of comparing the current environment with that of 2008, it would probably be fair to say that by August 2011 (when the MSCI China Index started its 33% slide) the mood with regard to these structural issues was, oddly, actually worse than in the global financial crisis. Without going into detail, we will briefly restate our stance on the main points in so far as they relate to risks for the banking sector which is what investors should be most concerned about. First, of the approximate Rmb10.7tn in LGFV liabilities, bank loans account for around Rmb8.5tn. The government either has direct repayment obligations or direct guarantees on around 84% of those liabilities, leaving just 16% for which the government is not directly responsible. Second, the central government is more than capable of meeting any LGFV-related liabilities. As the next table shows, central government gross debt is 17% of GDP and rises to 80% if LGFV and other (eg, Ministry of Railways) liabilities are included. This is lower than Japan (220% of GDP), the US (92%) and Germany (80%).
China government-related liabilities (2010)
Local government liabilities Central government debt Policy bank bonds Central bank bills Bank restructuring costs Ministry of Railways Total potential liabilities
Source: CEIC, Daiwa estimates
Local government liabilities: repayment schedule (2010)

Total Year Rmb tn % of total 2011 2.62 24.5 2012 1.84 17.2 2013 1.22 11.4 2014 0.99 9.3 2015 0.80 7.5 2016 & after 3.24 30.2 Total 10.71 100
Source: National Audit Office
No direct Direct repayment Direct warranty repayment or obligation or guarantee guarantee Rmb tn % of total Rmb tn % of total Rmb tn % of total 1.87 27.8 0.36 15.6 0.39 23.5 1.30 19.4 0.30 12.7 0.24 14.7 0.80 11.9 0.23 9.7 0.19 11.6 0.62 9.2 0.23 9.7 0.15 8.9 0.49 7.4 0.18 7.6 0.13 7.8 1.63 24.4 1.04 44.6 0.57 33.6 6.71 100 2.34 100 1.67 100
Third, as far as the property market is concerned, we note that typically only one third of development financing is provided by bank loans; and with a 5060% loan-to-value ratio on residential property, we would need to see a permanent 40% decline in property prices for loans to move into negative equity. The sector therefore has a large cushion to protect itself from further property price weakness. Finally, much could be written on how these issues as a whole might affect the banks the key issue at the heart of the structural concerns. We would simply point to two factors: 1. Sector provision coverage is 249% of NPLs and loan loss reserves are just above 2%. Core and total capitaladequacy ratios are well above required levels. 2. Our current forecast for 2012 sector NPLs is 2%. For the ratio to reach 5% it would require a 50-60% drop in national property prices and for 10% of LGFV and small enterprise loans to go bad. To reach a ratio of 10% of NPLs (where banks would be making losses and book value would be eroded), it would require a 60% property price fall and 20% of LGFV and small enterprise loans to go bad. This is, of course, only a very brief summary of our views on systemic issues, but we reiterate our belief that a crisis remains a low probability.
Rmb bn 10,717 6,753 5,160 4,091 3,582 1,592 31,895
% of GDP 27 17 13 10 9 4 80
China has more tools at its disposal

It should also be pointed out that, unlike in Europe, the China Government has a range of tools at its disposal to deal with any increase in systemic risks. Nominal interest rates are not at rock-bottom levels, as in other major economies (the US, Japan, Germany, the UK, etc.), and the benchmark RRR remains elevated. The 50bps RRR cut to 21.0% on 30 November this year, the first since 2008, suggests that while the government is in no mood to provide a global financial crisis-style economic stimulus, equally it is unlikely to stand idly by and watch the credit squeeze get out of hand. As the next chart illustrates, the major driver of reserve ratios in China is actually the change in foreign exchange reserves.
In any case, the peak of any potential LGFV debt problems would not be seen until 2016, since most obligations without government guarantees will only fall due in that year and beyond.
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3 January 2012
China: F/X reserve trends drive the RRR

800 700 600 500 400 300 200 100 2005 2006 2007 2008 2009 2010 2011 China RRR % (RHS) China Increase in F/X reserves (YoY US$bn)
Source: Bloomberg
25 20 15 10 5 0
Before we get too carried away, we certainly acknowledge that China faces significant long-term challenges, including: Rebalancing the economy away from investment-led growth without triggering a slump in growth (gross fixed capital formation has contributed a huge 5pp of GDP growth in the last 10 years). Dealing with the pressure on Chinas world factory status from rising labour costs (at the current pace, per capita GDP will almost double to US$10,000 by 2016). Finding new sources of employment for the countrys growing urban labour force. Reducing money supply growth to a more sustainable level to avoid future asset bubbles. These are huge issues which should not be underestimated, in our view. However, they are likely to unfold over the course of the next five years and do not constitute a systemic shock of the kind that equity investors appear to have been pricing in during the darker moments of 2011. To conclude, then, we do not see any meaningful risk of a structural crisis breaking out in China in the near term; the China Government has the will and the means to intervene to prevent such crises. On that basis, we would argue that it is legitimate to use historical equity valuations as a benchmark since we do not subscribe to the view that a looming systemic crisis in China renders all such comparisons irrelevant.
The PBOC uses the RRR to sterilise the US Dollar inflows associated with Chinas current account surplus which would otherwise inflate the Renminbi money supply. Of course, even when the reserves line is declining, F/X reserves are still growing, but nevertheless, the monthly change in the absolute level of the reserves is the key driver of the reserve ratio. The surge in F/X reserve growth in 2006-08 drove the RRR up from 7.5% to 17.5% over that period. The slump in exports during the global financial crisis allowed the RRR to retreat to 15.5% by the end of 2008, but it started to rise again from early 2010 to a peak of 21.5% as reserve growth re-accelerated. It was no surprise then to see the first RRR cut in three years in November this year as reserve accumulation has slowed. We expect another 200bps cut in the RRR by 1H12, which would still leave it higher than the pre-Lehmans crisis level of 17.5% (August 2008). The fact that the November 50bps cut alone released around Rmb396bn of liquidity into the banking system gives some idea of the potential liquidity cushion available. There have been other signs of selective easing in the form of a tentative relaxation of credit quotas, particularly on SME lending. In addition, the announcement in October that two cities (Shanghai and Shenzhen) and two provinces (Zhejiang and Guangdong) would undertake trial municipal bond issuance the first time local governments have been able to issue bonds suggests that the central government is prepared to be more flexible in addressing local funding needs. Typically in China, new policies of this type are trialled on a limited basis and if successful are then rolled out on a wider basis. While this would not, at a stroke, remove all concerns on the LGFV front, it would be an important step towards removing the project-based risk on individual local government loans and consolidate risk up to the sovereign level.
Do we need another Lehmans moment?

One cautionary note needs to be sounded at this point. Old market hands might point out that bear markets often end with an event that causes a final capitulation sell-off and establishes a base for the recovery. In the global financial crisis, that event was the Lehmans bankruptcy on 15 September 2008. In that case, the banks collapse triggered the decline which proved to be the low point of the global financial crisis bear market around six weeks later. Moreover, it was the resultant loss of confidence in the global banks which triggered the combined monetary and fiscal stimuli from the worlds central banks, which in turn powered the subsequent equity market recoveries. We are still waiting to see whether this crisis will produce its own Lehmans moment and if so, what form it might take? By far the most obvious candidate is a crisis relating to the European sovereign debt problem, although it would be foolish to discount the possibility of another private sector failure MF Global may not be the last domino to fall.
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3 January 2012
The clearest risk remains a default on the part of a European government and the associated potential for a wholesale disintegration of the Euro. For the financial markets, the threat to the survival of the large European banks would be the focus of attention. The subject is so large and the situation is changing so rapidly that it would really be pointless in a report of this kind to dive too deeply into the detail. We will however, quote Daiwas European economist, Tobias Blattner, who neatly sums up the issue by identifying: the structural problem underlying banks ever worsening inability to access wholesale funding, which is rooted in investors concerns about their exposure to sovereign debt. A lasting improvement in banks funding conditions can only come from a resolution to Europes debt crisis. In other words, markets may rise and fall on a daily basis in response to politicians tinkering at the edges, but only a resolution of the fundamental problem of over-indebted European economies will provide a lasting solution. Key near-term concerns include: Doubts about the capacity of the European Financial Stability Facility (EFSF) to launch bailout programmes for Italy and Spain if they were to lose market access. Potential further ratings agency downgrades, with S&P already putting the majority of Euro area member states on credit watch. We provide the following quote from Tobias Blattner: Rating agenciesstill pose a massive threat to an orderly unwinding of the crisis, in our view. The ability of national governments to overcome the key stumbling block, namely an agreement on a process to produce stricter fiscal rules for Euro area members. 1Q12 could be a critical time, as Daiwa expects a March deadline for an agreement on the fiscal rules; given the highly sensitive nature of the issue, this could well turn into a political football, with parliamentary votes and possible referendums in member states providing plenty of potential for negative headlines in the first three months of the year. Unfortunately, this coincides with a 1Q12 spike in maturities of European bank bonds (more than 250bn), with Italy alone set to issue 100bn of bonds in the period. The good news is that Daiwas European economics team believes that the Euro itself will survive. The bad news, for China and other export-driven economies, is that economic growth will be a victim of the crisis, and Daiwa now expects a 0.2% YoY contraction in Euro area GDP in 2012.
So, while there is no immutable law that says we have to have a Lehmans moment, the European quagmire provides a clear potential source of such a shock. Overall, this global crisis has a somewhat different feel to the global financial crisis in that it is likely to be a long dragged out affair; the toolbox looks much emptier this time than in 2008/09 when fiscal stimulus, slashing of interest rates to zero and quantitative easing were available to shock the patient back to life. This underpins our view that China will remain in a trading range well into 2012 as the attractions of cheap equity valuations are offset by worries about slowing economic growth and external shocks.
Market outlook
Bringing this all together, we expect the China equity market to provide positive returns for investors in 2012, but something of a trading mentality will be needed as the first half at least is likely to be a volatile time. However, when we talk about a trading approach, we mean that the inevitable periodic bouts of negative news flow whether on earnings forecast cuts, concerns about insufficient monetary loosening, external issues like the Eurozone problems, etc. will offer opportunities to build positions in stocks that are indentified as being attractive on a medium-term perspective. We discuss specific sectors and stocks which we believe fall into this category later in the report. It is worth re-emphasising that our medium-term confidence rests partly on the belief that historical comparisons remain valid, and history shows us that buying Chinese equities at, or even above, current valuation levels (the MSCI China 12-month forward PER is 8.3x) has been rewarding on a 6-12 month view.
MSCI China Index: returns (since 2003) from entering the market at different PER levels
Forward PER 9x 10x 11x 12x
Source: MSCI, IBES
Avg. 6m % return 47.4 26.9 20.6 15.9
Avg. 12m % return 71.0 47.3 32.2 26.5
Moreover, even if earnings forecasts do prove to be over-optimistic and valuations higher than they appear at the moment, investors have a significant cushion in the sense that buying at 9x or 10x 12-month forward earnings historically has also offered attractive returns. Another way to think about this is to ask where valuations would be if the earnings forecast downgrades that took place in 2008-09 were to be repeated in 2012. As discussed above, we do not think this is likely, but it is an interesting exercise
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3 January 2012
nevertheless. The table below shows the peak-to-trough changes in 12-month forward earnings forecasts during the global financial crisis.
MSCI China Index: where would China 12-month forward PERs be if the 2007-09 earnings downgrade cycle were to be repeated?
% performance Current 12- Adjusted 12from peak to month forward month forward tough PER (x) PER (x)** (37.9) 8.2 12.9 (38.5) 16.0 19.1 (42.3) 10.3 10.5 (0.9) 24.9 24.9 15.9 17.6 17.7 1.4 9.4 10.2 22.2 8.5 10.6 62.8 8.3 8.8 9.1 5.7 7.7 (37.2) 8.0 13.0 (65.5) 9.7 15.2 (50.1) 18.2 29.3 (72.3) 10.2 13.1 (49.5) 5.5 8.2 (33.8) 22.7 36.5 (33.4) 6.1 8.4 (47.8) 5.5 12.6 (40.4) 16.2 25.0 (59.5) 13.1 19.1 (1.2) (109.6) n.a.** (8.3) 12.2 18.3 (68.2) 7.1 13.1 (49.9) 7.9 38.2 (51.5) 10.2 19.5 (31.3) 10.7 18.8 (44.1) 7.2 10.1 (61.8) 13.6 1009.8 (12.0) 8.4 16.6 (26.2) 6.3 43.2
China: GDP growth and inflation gap

(YoY % ) 16 14 12 10 8 6 4 2 0 (2) (4)
China Communications Equipment Water Utilities Personal Products Internet Software & Services Wireless Telecoms Automobiles Energy Equipment Commercial Banks Oil Gas & Fuels Transportation Infrastructure Diversified Telecom Electrical Equipment Construction Materials Beverages Construction & Engineering Real Estate Management & Development Food Products Specialty Retail Marine Insurance Machinery Metals & Mining Diversified Financial Services IPPs Chemicals Computers & Peripherals Industrial Conglomerates Airlines
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
Jul-09
Jul-10
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
GDP
Source: CEIC
CPI
The impact of this squeeze in equity valuations is clear; the MSCI China Index valuation expands when the GDP-CPI gap widens and contracts when it narrows.
China GDP-CPI gap and MSCI China Index PER
(% ) 14 12 10 8 6 4 2 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 GDP growth minus CPI (LHS)
Jan-11
Jan-04
Forecast
12M fwd PER (RHS)
Source: MSCI, IBES Note: PERs are based on share prices of 19 December 2011 Note: * Loss making; ** For the adjusted 12-month forward PER, we have applied the downward revisions seen in 2009 to the current consensus 12-month forward PERs
So, in a repeat scenario of 2008-09 the current 12month forward MSCI PER would rise to 12.5x this is certainly a less attractive proposition than implied by current forecasts, but again, it is an entry level that has yielded positive 6-month and 12-month returns in the past. In summary then, we do not believe that equity valuations would be stretched even in the event of a 2008-magnitude earnings downturn. Another way to consider downside risk is to put the current outlook for the key macro variables into the market context to see how they have historically affected equity valuations. We have discussed in previous reports the idea that inflation in itself is not necessarily negative for equity valuations in China. As the next chart shows, the key periods are those in which inflation is still accelerating but economic growth has started to slow. At that point the gap between the two narrows and we have an environment that is unfavourable for equities as tight money meets slowing earnings growth.
The good news is that the gap bottomed at 2.6% in July 2011 and has rebounded to 4.3% (based on November data), and should hit 4.9% by 2Q12, according to our forecasts. Since we believe inflation is not going to collapse as dramatically as it did in the global financial crisis (when the CPI fell from a peak of 8.7% to a trough of -1.8%) and GDP growth will not recover as quickly either, the rebound in the gap should be relatively modest this time. Nevertheless, we expect the change in the trend to put a solid floor under valuations even if it is not likely to catapult them into a new bull trend in the near term.
- 18 -
Jul-11
(x ) 30 25 20 15 10 5 0

3 January 2012
Liquidity wild card

There is one final comparison with the period of the global financial crisis to provide food for thought. In 2007, the equity market was propelled higher at least in part by a surge in individual investor participation. That year saw a 50% increase in the number of new securities trading accounts (to 113m). By early 2008 (there are no statistics available before that date, unfortunately), the number of active accounts was above 20% of the total.
Shanghai SE: active share trading accounts as % of total
(% ) 25 20 15 10 5 0
China: household deposits have risen rapidly in Rmb terms

(Rmb bn) 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
YoY increase in household deposits (Rmb bn)

Source: CEIC
Source: China Securities Depository and Clearing Corp. Note: Four-week moving average
Finding a profitable home for surplus assets in China has never been easy, thanks to the controlled interestrate environment. Although the shadow lending sector, which has certainly absorbed significant amounts of cash in the past 1-2 years, will probably continue to grow, property has been the main outlet for excess savings. It was therefore no coincidence that activity in the real estate market picked up as investors retreated from equities.
China: annual residential transactions
(Rmb bn) 5,000 4,000
Feb-08
Feb-09
Feb-10
Aug-10
Aug-09
Aug-08
Nov-08
Nov-09
Nov-10
Feb-11
At the same time, daily trading volume as a percentage of market capitalisation surged from the 0.2-0.4% range to a peak of over 1.5%.
Shanghai SE: daily trading volume as % of market cap
(% ) 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 2003
Source: CEIC
May-08
May-09
May-10
May-11
3,000 2,000 1,000 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011* China annual residential-property transaction value
Source: CEIC Note: * Provisional figures to October 2011
2004
2005
2006
2007
2008
2009
2010
2011
Daily turnover as % of market capitalization 20-day MA
Real estate will undoubtedly remain a core investment asset but, as the preceding charts show, transaction volumes have declined as price appreciation has slowed.
The dramatic (and sustained) drop in both these indicators suggests that since the 2008 bear market there has been a wholesale retreat from equities on the part of local investors. Meanwhile, the stock of available investor liquidity, as measured by the size of total household deposits, has continued to grow apace. Although the percentage growth rate has slowed from the peak, the large base means we should look at the absolute Renminbi growth. This has accelerated since the start of the bear market, with the pool of household deposits almost doubling in size from Rmb17tn in 2007 to Rmb32tn currently. - 19 -
2011

3 January 2012
China residential prices are still consolidating

(% YoY) 25 20 15 10 5 0 (5)
Sector recommendations
Below we summarise our sector views for 2012 with our top stock pick for each. There are obviously many factors that contribute to the individual sector views. However, one theme that does emerge is a preference for those industries that have moved on since the global financial crisis in terms of consolidation or other sectoral changes (eg, cement, autos and, to a more limited extent, real estate), or that have emerged unscathed from the crisis and have continued to evolve since then (eg, banks). On the other hand, we are more cautious on those industries where little has changed in terms of unfavourable industry structure and lack of consolidation (eg, steel, metals), or where regulatory regimes mean returns are volatile and generally low (eg, IPPs). Other industries are somewhat stuck in the middle the best example being the integrated oil companies, where long-awaited product-pricing reform has still not materialised.
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
China average commodity building selling price: residential

Source: CEIC
We would readily acknowledge that just because the pool of household liquidity has grown substantially since the global financial crisis, and the allocation to equities has apparently fallen, there is no guarantee that domestic interest in the stock market will pick up imminently. However, we would suggest that this is another factor underpinning equity valuations; at the least, there does not appear to be a risk of hot money exiting the market.
2011
- 20 -

3 January 2012
Sector recommendations
Sector Automobiles Rating Comment Positive The Auto Sector is also, to a certain extent, still feeling the impact of the global financial crisis and its aftermath. As a result of the impact of the economic slowdown, passenger car sales fell below the long-term trend in 2H08 and early 2009, with government-stimulus measures then triggering a sharp rebound in 2H09 and 2010. This has distorted the organic growth rate in auto sales to some extent, with the incentives effectively pulling forward demand on the one hand, and then depressing it once the stimulus measures were removed. This accounts for the slowdown in sales seen so far in 2011 (we forecast full-year growth of 7.2% YoY) and the rebound to >9% YoY that we expect in 2012. Within the sector, we prefer the joint venture companies and quality domestic brands. Aviation Neutral The sector had a tough time during the global financial crisis. A combination of falling yields (-3% YoY in 2008 and -12% in 2009, the largest decline in more than 10 years) and losses on fuel hedging pushed all three domestic carriers into the red. In our view, the current downturn should be less dramatic: in 2012 we expect moderate declines in domestic passenger load factors and yields due to lower fuel surcharges and high-speed railway competition. The outlook for the international business looks better. Overall industry dynamics have changed little since the global financial crisis but, despite our forecast of earnings declines in either or both of 2011 and 2012, the industry does not look in danger of slipping into losses in this cycle. Banks Positive Having sailed through the global financial crisis unscathed, the Bank Sector has continued to evolve. From a cyclical perspective, this time there should be a smaller negative impact on net-interest margins (NIMs) when interest rates fall compared with the experience of the global financial crisis, but equally there are potentially greater asset-quality risks now. However, banks have higher capital and provisioning levels, and we note that NPLs and credit costs are simply normalising at the moment. Ongoing deregulation means a greater emphasis on risk-weighted returns, and we would focus on banks with strong capital bases, lower LDRs, strong deposit franchises and good cross-selling abilities in order to raise the contribution from fee income. In summary, what is happening in the sector now is normalisation, not crisis. As China transforms from a high-growth investmentdriven economy to a lower, but more balanced, trajectory, boom-bust cycles should moderate. Banks will play a key role and will be transformed alongside. A key sector to hold in 2012. Cement Positive The cement industry has changed significantly since the 2% YoY drop in demand experienced in 2008. At that time, the industry was fragmented, there was little supply discipline, and capacity growth was running at double-digit levels. Now, the demand outlook is less positive again, but this time supply discipline is better, the industry has consolidated and the government is suspending approval for new production lines and closing obsolete lines. Capacity growth will lag demand growth in 2011, 2012 and 2013. Sector earnings growth may be flat YoY in 2012 as volume growth may not be enough to offset declines in selling prices, and given the high 2011 base. However, we believe that the market appears to some extent to be putting the cement sector in the same basket as the steel companies, which we see as unfair, given that the fundamentals of the latter have barely improved since the global financial crisis. Consumer NR The Consumer Sector has changed significantly since 2008. First, investors have a lot more choice, with around 25% of the companies in the sector having listed since the beginning of 2009. Perhaps relating to the first point, we believe that levels of perceived competitive risk have risen dramatically over the past three years, leading to a collapse in valuations in the sportswear and department store sub-sectors. We also note how large, liquid defensive stocks in consumer staples have increased their valuation premium in the current time of uncertainty versus the end of 2008, probably helped by the theme of industry consolidation. Lastly, it is worth mentioning that this sector continues to be accident-prone: Over 2009-11, we have seen the Esprit brand fall to pieces, Bawang collapse after being falsely accused of using harmful chemicals in its shampoo, corporate governance issues at Chaoda and poisoned pigs at China Yurun. This may explain investors risk-averse attitude towards the sector, but we believe that there are real opportunities emerging at current valuations for consumer discretionary stocks with solid fundamentals. Expressways Neutral The Expressways Sector did not prove to be particularly defensive in the global financial crisis-driven downturn, with average daily traffic and toll revenue falling YoY for most months in 2008-09. This might seem surprising at first glance, but upon reflection, the sharp slowdown in trade and 12 months of declining commercial vehicle sales go some way to explaining the weakness. Industry performance has been better in 2011, with most toll roads maintaining positive YoY traffic and revenue growth. The sector has been overshadowed by government investigations of alleged excessive industry charging, although we believe this should have little effect on listed stocks. The outlook seems better for toll-roads in 2012. At the stock level, the coastal expressways are more mature now and could suffer from an export slowdown. We prefer those stocks focused inland. Gaming and Positive Of all sectors, gaming is the one that has undergone the biggest change since 2008, as the market cap is up significantly since then, with some key names listed only after the global financial crisis. Gaming revenue growth Leisure slowed sharply in September 2008 in reaction to the Lehman collapse. We expect YoY Macau gaming revenue growth to slow (2010 +58%, 11M11 +44%) to +20% in 2012. However, this remains a high-growth sector and the relative attractions of the story remain in an environment of slower growth generally in China next year. Heavy Machinery Negative Most categories of construction machinery experienced a cyclical downturn in 2009, but then rebounded sharply in 2010, as the impact of the fiscal stimulus kicked in. However, sales momentum has been decelerating each quarter in 2011 so far, and there are also some risks in terms of accounts receivable, eg, Zoomlion's finance lease sales, funded by the companys balance sheet, now account for 30% of sales (compared with 4% in 2007). Machinery makers are towards the end of the 'food chain', in that orders for their products are among the last to come in when there is a pick-up in FAI growth. On that basis, we expect shipments to remain weak through 1H12. Market sentiment will inevitably remain cautious in recognition that there will not be anything approaching 2009's FAI boom. On that basis, we feel it is too early to revisit the sector. IPP Neutral The IPPs endured a tough time during the global financial crisis; 2008 was terrible. The combination of negative YoY growth in power consumption and an 87% trough-to-peak spot coal price rise led the industry into losses at the EBIT level. Profits did rebound in 2009, although EBIT margins have been in a downtrend ever since, hitting 7.0% in 3Q11, compared with the 14.3% 3Q09 peak. Moreover, both sector EBIT margins and ROEs are still below pre-2008 levels. Meanwhile, gearing remains high (EBIT/interest coverage is 1.7x compared with 3.7-5.6x in 2005-07). In short, this is a sector where little or nothing has changed for the better since the global financial crisis. Looking ahead to 2012, we see little potential for much relief on the input side as coal prices are unlikely to collapse as they did in 2H08, while the recent tariff increase could easily be reversed if IPP profits recover.
Source: Daiwa; note: prices in local currency as of close on 19 December 2011
When a report covers six or more subject companies please access important disclosures for Daiwa Capital Markets Hong Kong Limited at http://www.daiwacm.com/hk/research_disclaimer.html or contact your investment representative or Daiwa Capital Markets Hong Kong Limited at Level 26, One Pacific Place, 88 Queensway, Hong Kong.
Stock pick Ticker Dongfeng Motor 489 HK Great Wall Motor 2333 HK
Rating Price 1 12.34 1 11.54
Target price 16.90 15.30
Air China
753 HK
5.33
7.50
ICBC
1398 HK
4.60
5.85
CR Cement
1313 HK
5.75
9.45
Li & Fung
494 HK
14.26
22.70
Yuexiu Transport 1052 HK
3.31
6.00
Galaxy Sands China
27 HK 1928 HK
1 1
13.90 20.75
19.54 26.25
Zoomlion
1157 HK
8.10
8.50
CR Power
836 HK
14.0
18.00
- 21 -

3 January 2012
Sector recommendations (contd)

Sector Infrastructure Rating Comment Neutral The Infrastructure Sector was a key counter-cyclical play in 2008-09, thanks to the fiscal-stimulus programme (of which 38% was allocated to transport infrastructure). LGFV-funded local projects were another source of growth. However, operating margins actually fell throughout the projects, thanks to a combination of higher raw material and labour costs, and relatively inefficient project management, as the companies dealt with a glut of new business. Ongoing safety issues for high-speed railways, changes at the Ministry of Railways, and funding shortages have put the brakes on that part of the spending programme. 2012 should be slightly easier from a funding perspective, though. Within the Railway Sector, we prefer the equipment manufacturers over the construction companies, while the most attractive area right now is marine-related infrastructure, hence our preference for China Communications Construction. Insurance Positive The Insurance Sector has changed significantly since the global financial crisis. On the one hand, the growth environment appears to have become tougher for the life companies, while growth for the P&C industry is currently stronger than three years ago. Another key change is that equity-investment portfolios are much smaller now, which should limit the impact of stock-market weakness compared with 2008. The industry is facing some big long-term threats in the form of premium growth, the homogenous nature of products, and the likely challenge of growth in bancassurance products coming from the bank-owned insurers. However, sector valuations are very cheap by historical standards and there is significant upside to our target prices. Oil & Gas Neutral In most respects, the industry fundamentals have changed little since the global financial crisis. Long-awaited structural change particularly in the area of downstream petrochemical pricing is coming, but slowly to the Oil & Gas Sector. Given the China economy's sensitivity to energy and product prices, the government will likely be cautious in moving on deregulation; Sinopec and Petrochina are likely to still have to bear some subsidy burdens on downstream products. In light of that, it is not encouraging that refining capacity growth is continuing. International M&A will remain an active theme in the sector for all three companies. Overall, as in the global financial crisis, CNOOC is likely to outperform its more integrated peers. Power Equipment Positive The sector had a difficult time in 2008 as falling power demand in China led to production-schedule cuts for the power-equipment manufacturers. With the added burden of high raw-material prices, margins fell. In 2011, the equipment manufacturers are less dependent on thermal orders now, and with the growing importance of hydro, wind and nuclear power equipment. China is still suffering from power shortages, especially in the coastal provinces. This, together with increased orders for gas-fired equipment and the resumption of nuclear order flow, will support business in 2012. Moreover, raw-material costs (primarily steel), are not expected to be as onerous in this cycle. Property Positive Property has been in the spotlight since the global financial crisis thanks to government price-cooling policies. However, we note that even in the midst of the global financial crisis in 2008, when China's residential GFA sales fell 19% YoY, ASPs only declined by 0.3% (followed by a 53% YoY and 22% YoY increase in GFA sales and ASPs, respectively, in 2009). Now, with credit tightening and the Home Purchase Restriction scheme, GFA sales slowed to +9% YoY in Jan-Oct 2011 (we expect flat YoY sales overall for 2011), with a decline in sales in the major coastal cities offset by increases in the inland tier 3/4 cities. ASP growth remains positive, however, at +5.1% YoY for Jan-Oct 2011, and developers have cut prices to boost cash flow. The policy overhang has pushed the average sector NAV discount to 60% since September (it bottomed at 72% in October 2008). So, although near term there is unlikely to be much good news, investors appear to be pricing in a hard landing, which we think is unlikely. Focus on companies with affordable products and exposure to tier 3/4 cities. Solar Neutral The solar industry has undergone significant changes since the global financial crisis. Polysilicon and module prices fell dramatically in 2008-09, leading to a collapse in profit margins throughout the supply chain. On a positive note, the market share of the China manufacturers increased significantly in the wake of the crisis, but on a less positive note, the downturn did not trigger industry consolidation. With almost 40% excess capacity, weak European demand, rising inventory and falling product prices, 3Q11 was bad for the Solar Sector. However, we expect the ROIC to bottom out in 2H12 and industry consolidation to start at some point in 2012. That will play to the low-cost structure and large scale of the manufacturers, such as GCL Polysilicon. Steel Neutral Steel is another sector that has changed little since the global financial crisis. At that time, the initial recovery from the fall in crude-steel output was cut short by a big increase in input costs (mainly iron ore) and an inability to pass that along due to a lack of pricing power. The current environment is even more challenging. There has been almost no industry consolidation, meaning very low pricing power, with producers facing endemic overcapacity and low returns (mid single-digit ROEs). The industry operating rate, which recovered from its 2008 low (albeit to well below pre-global financial crisis levels), will probably decline for the next four years. EBIT margins of 5-10% forecast vs. 10-15% prior to the global financial crisis. On the positive side, the volatile performance of the steel stocks offers regular trading opportunities, while the depressed sector PBRs also offer some upside for nimble investors. Telecommunications Neutral Analysing the performance of the telecoms during the global financial crisis is complicated by the fact that it coincided with a major industry shake-up (3G start-up and asset shuffling between the operators): it was this, rather than the economic downturn, which dragged down sector profits in 2009. The good news is that a relatively weak historical correlation between China's GDP growth and the telecoms sector's revenue implies that the sector can be a defensive haven in a downturn. Indeed, telecoms revenue growth has exceeded GDP growth since 4Q10. Mobile penetration, price competition and regulatory intervention are key revenue drivers, rather than headline growth. However, that defensiveness is somewhat offset by the fact that mobile competition remains intense now that penetration is more than 70%, and the margin squeeze across the sector in the most recent 3Q11 results confirms this. Thermal Coal Positive The Coal Sector saw a stimulus-driven jump in demand in 2009-10 (thermal coal demand +12-13% p.a.), better than the 7.8% YoY growth we forecast for 2012. However, prices will be much less volatile this time, with no repeat on the cards of the 67% YoY surge in 2008 and the subsequent 40% YoY collapse to the 2009 trough. The combination of that price collapse and the high stock valuations at the time triggered an 83% peak-to-trough share-price drop for the three coal companies. This time, there has been a more modest increase in coal prices, and valuations are at a more comfortable level. On a more cautious note, transport bottlenecks remain a problem and industry consolidation is proceeding very slowly. Key state-owned mines accounted for 50% of output in 2010, which is only a marginal increase from the 48% level in 2006.
Source: Daiwa; note: prices in local currency as of close on 19 December 2011
Stock pick China Comm. Cons.
Ticker 1800 HK
Rating Price 1 5.93
Target price 7.50
CPIC
2601 HK
20.9
43.15
CNOOC
883 HK
13.58
21.50
Shanghai Electric 2727 HK Harbin Electric 1133 HK
1 1
3.50 6.61
4.70 9.42
Evergrande
3333 HK
3.02
5.00
GCL Poly
3800 HK
2.08
3.10
Baosteel
600019 CH
4.71
5.70
China Telecom
728 HK
4.50
5.22
China Shenhua
1088 HK
32.6
39.70
- 22 -

3 January 2012
PV monthly sales volume trend (6-month moving average)

PV (units) 1,800,000 1,600,000 1,400,000 1,200,000 1,000,000 800,000 600,000 400,000 200,000 0 Jan 2004-June 2008, China PV sector ex perienced stable and steady growth with a monthly rate of 1.8% , or 25% YoY
Automobiles Positive
Jeff Chung (852) 2773 8783 (jeff.chung@hk.daiwacm.com)
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Jun-05
Jun-06
Jun-07
Jun-08
Jun-09
Jun-10

The long-term case for rising car sales in China is well known. However, the growth trend in 2011 has been distorted by government policies which started out as counter-cyclical but have become pro-cyclical. We have plotted the historical monthly trend in passenger vehicle (PV) sales volume in the chart that follows. According to the correlation, from 2H08 to early 2009 Chinas PV monthly sales volume underperformed the long-term trend, whereas from 2H09 to January 2011 it outperformed the long-term trend due to government stimulus packages.
PV monthly sales volume trend (simple regression)
PV (units) 1,800,000 1,600,000 1,400,000 1,200,000 1,000,000 800,000 600,000 400,000 200,000 0 Government stimulus encouraged purchases and front-loaded demand from the future
Source: CEIC, Daiwa
Back to 2008: actual sales volume vs. our organic growth estimates
Monthly growth rate assumption of 1.8% 572,584 582,865 576,492 551,434 540,158 533,067 532,430 553,193 579,660 616,907 666,536 718,490 767,400 805,065 847,645 888,824 908,418 943,597 982,696 1,064,708 1,079,072 1,121,468 1,149,362 1,150,515 1,140,246 1,077,503 1,090,403 1,081,321 1,096,981 1,147,291 1,192,379 1,291,255 1,282,470 1,305,573 1,295,245 1,244,881 1,211,055 1,123,321 1,145,037 Actual sales volume 488,219 451,299 552,808 538,457 522,843 584,609 610,596 607,299 772,353 830,974 829,071 872,894 832,596 858,278 1,015,069 946,463 1,036,422 1,103,348 1,315,990 942,942 1,264,958 1,110,874 1,043,220 1,042,818 946,172 1,018,977 1,211,428 1,203,174 1,339,756 1,308,575 1,528,965 967,200 1,347,600 1,142,300 1,042,900 1,109,200 1,011,842 1,095,200 1,319,500 Total Actual less our assumptions: differences (84,365) (131,566) (23,684) (12,977) (17,315) 51,542 78,166 54,106 192,693 214,067 162,535 154,404 65,196 53,213 167,424 57,639 128,004 159,751 333,294 (121,766) 185,886 (10,594) (106,142) (107,697) (194,074) (58,526) 121,025 121,853 242,775 161,284 336,586 (324,055) 65,130 (163,273) (252,345) (135,681) (199,213) (28,121) 174,463 1,309,642
2H08: demand underperformed the long-term trend
y = 401.74x - 2E+07 R = 0.8475
Source: CEIC, Daiwa
Where are we now?

We have sought to measure the front-loaded sales volume during the period spanning 2H08 to January 2011. In this exercise, we assume a linear growth rate and capture the relatively stable and steady growth period from 2005-2H08, with a monthly growth rate in PV sales volume of 1.8% as our base-case assumption. From this, we have then sought to derive what the organic PV sales volume would have been since July 2008 without distortions.
Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Jun-05
Jun-06
Jun-07
Jun-08
Jun-09
Jun-10
Jun-11
Jun-04
Source: CEIC, Daiwa
By comparing the historical figures and our forecasts, we estimate that the market is currently in a position whereby there are 1.3m front-loaded PV units. We go on to discuss how long it is likely to take for the market to absorb this front-loaded amount.
- 23 -
Jun-11
Jun-04

3 January 2012

When is the market likely to return to normal 25% YoY organic growth?
PV sales growth under different payback period assumptions
6 months 1.9 14.1 23.9 Payback time 12 months 4.3 21.8 24.3 18 months 5.1 24.0 24.6
JV and quality domestic brands should outperform the mass market

JV vs. domestic brands (sales-volume growth & market share)
80% 60% 40% 20% 0% (20%) -7% 2008 37% 40% 43% 2009 29% 2010 68% 44% 38% 48% 46% 42% 1% 11.4% Jan-Sep 2011 46% 44% 42% 40% 38% 36% Domestic brands JV brands RHS: Domestic brands PV market share
Source: CAAM, Daiwa
PV sales volume growth (%)

Source: Daiwa estimates
2011E 2012E 2013E
We assume three different scenarios, under which demand gradually absorbs the amount of 1.3m PV units with six-month, 12-month and 18-month payback periods, with assumptions of PV sales volume growth for 2011 of 1.9% YoY, 4.3% YoY and 5.1% YoY in our respective scenarios. Under our assumptions, if Chinas low car penetration allows a sustainable monthly sales-volume growth rate of 1.8% (25% YoY), then history suggests to us that the frontloading effect should have been largely absorbed and should become minimal by 2012, based on our 12-month and 18-month payback assumptions.
What if the organic growth rate since July 2008 slows to 12.5% YoY?
Sensitivity analysis under a 12.5% YoY PV growth rate
6 months 0.2 1.5 13.2 Payback time 12 months 3.2 10.1 12.1 18 months 4.2 12.8 11.8
PV sales volume growth (%)

2011E 2012E 2013E
The sales volume growth of domestic brands consistently outperformed that of the JV brands between 2008 and 2010 due to strong government subsidies. The domestic brands aggregate market share increased from 40% in 2008 to 46% in 2010. However, 2011 shows quite a different picture. Year-todate, YoY sales growth among the JVs has been much better than that of the domestic brands, coinciding with the domestic brands aggregate market share falling from 46% in 2010 to 42% so far in 2011. The removal of the government subsidies appears to have had a much greater impact on the local players, and suggests that the JV brands are more competitive with stronger organic growth potential in the China market.
Many JVs saw >10% YoY volume growth from January to July 2011
Although many Japanese JV brands experienced declining sales volumes from January to July 2011 due to supply chain distortions as a result of the Japan earthquake in March 2011, all other JV brands recorded positive volume growth of more than 10% YoY. (We base our calculations on this period, as we believe it represents the toughest period during 2011, from which we can build our worst-case forecast for 2012.)
Many people argue that PV sales-volume growth in China should not have exceeded 15% YoY since 2008, due to infrastructure bottlenecks, energy security limitations, etc. We therefore factor in these concerns and assume an organic growth rate of 12.5% YoY for PV sales volume since June 2008, with a diminishing growth effect materialising during 2013. With this set of assumptions, we estimate that the market may carry a front-loaded PV amount of 1.63m units. Under our three different forecast scenarios shown in the preceding table, we estimate that 2011 PV sales volume would be affected significantly in the six-month payback scenario, while our 12-month and 18-month cases suggest the market could return to a normal growth rate in 2012 and 2013, with double-digit growth in PV sales volumes exceeding 10% YoY. Here, our sixmonth payback assumption looks rather extreme, with negligible growth in 2011 and 2012, which we recognise as rather weak, matching the PV sales-volume growth figures for 2011 year-to-date.
- 24 -

3 January 2012
Jan-July 2011 sales performances: first-tier (JV brands)

PV market share in China (Top tier: JVs) 9%
8% 7% 6% 5%
Domestic brands with negative YoY sales-volume growth

Changhea Hafei Soueast SAIC (local) Haima GA-Chang Feng Hui Hang Qing nian DFPV JMC Hawtai GA-Gonow Foton BAW UFO Qingling Tianqi Motor Jiangxi Auto Total Other domestic brands Changan BYD Jinbei NJ-Changan Total
Source: CAAM, Daiwa
All other JVs
Japanese JVs
BJ-Hyundai DF-KIA Chang'AnFord-Mazda

0 10 20
GAC-Honda GAC-Toyota
(20)
FAW-Toyota 4% 3%
2% 1% 0%
DF-Honda
(10)
Jan-July 2011 YoY total sales volume changes 30 (Percentage)
Source: CAAM, Company, Daiwa
The correlation plotted in the preceding chart also shows that JV brands with larger market shares tend to register faster sales-volume growth than those with low market shares. Many of the Japanese JV brands saw their production return to normal levels in July and August. Overall, we expect their 2011 sales volume to be in line with that for 2010.
Jan-Jul 2011 YoY sales volume (%) (14.9) (40.8) (11.2) (27.4) (15.7) (10.1) (23.6) (7.6) 41.3 (69.0) (74.2) (30.4) (32.7) (7.4) (3.4) (63.4) (100.0)
Market shares (Jan-Jul 2011) (%) 0.88 0.69 0.67 0.63 0.38 0.25 0.19 0.19 0.19 0.17 0.08 0.08 0.06 0.04 0.01 0.00 0.00 4.52
Many domestic brands have had a hard time in 2011

Jan-July 2011 sales performances: second-tier (domestic brands)
PV market share in China (Second tier: Domestic brands) 5.0% 4.5% Chan'an Chery 4.0% 3.5% BYD Geely 3.0% This part of domestic 2.5% players are in trouble Great Wall 2.0% 1.5% 1.0% 0.5% 0.0% (150) (100) (50) 0 50 100 150
Source: CAAM, Companies, Daiwa
(16.7) (19.3) (15.6) (16.2)
4.3 3.2 1.4 1.3 10.3
Thematic picks: Dongfeng Motor and Great Wall Motor

We have Buy (1) ratings on Great Wall Motor (GWM) and Dongfeng Motor (DFM). GWM is trading at a PER of 6.4x based on our 2012 EPS forecast. We believe GWM has a strong sales-growth outlook and deserves to trade at least in line with the MSCI China Auto benchmark PER of 8.5x for the following reasons: 1) We remain positive on GWMs 2012 outlook and forecast 30% YoY sales-volume growth, 2) the new models, H6 and C50, should improve the companys gross-profit margins, and 3) export sales remain a sweet spot for GWM and we forecast a 20% YoY improvement in export-sales volumes for 2012. DFM is trading at a PER of 6.9x based on our 2012 EPS forecast and appears to have bottomed out at the average PER -1sd range. Its valuation looks undemanding to us, as it is lower than the current PERs of DFMs local peers (10.2x) and global peers (7.7x). We look for DFM to benefit from an expected recovery in demand and believe the stock deserves a PER close to our estimated sector average of 9.4x, given the companys: 1) stable market share, 2) strong product mix, and 3) high utilisation rate.
Jan-July 2011 YoY total sales volume changes (Percentage)
We estimate that 21 of the 36 domestic brand car makers in China recorded year-on-year sales-volume declines from January to July 2011. We believe car makers with low market shares (below 1%) and negative sales growth (shown in the blue box in the preceding chart) will feel the pressure from JVs and quality domestic brands in 2012 if the gloomy economic conditions continue. We estimate that this group of car makers accounted for a combined 4.5% of the car sales market in China over January-July 2011. We present the details in the following table.
- 25 -

3 January 2012
Automobiles: target prices

Company Dongfeng Great Wall Brilliance GAC Bloomberg code 489 HK 2333 HK 1114 HK 2238 HK Share price 19-Dec-11 (local curr.) 12.34 11.54 7.7 6.52 Six-month Upside/downside target price potential (local curr.) (%) 16.9 37 15.3 33 10.0 30 6.8 (4) 2012E PER (x) 6.9 6.4 13.5 7.2 Valuation basis 9.4x PER based on 2012E EPS 8.5x PER based on 2012E EPS 17.5x PER based on 2012E EPS 7.5x PER based on 2012E EPS
Source: Daiwa forecasts
Automobiles: valuation summary

Company Dongfeng Great Wall Brilliance GAC Share price Six-month Bloomberg 19-Dec-11 target price +/code (local curr.) Rating (local curr.) (%) 489 HK 12.34 Buy 16.9 37 2333 HK 11.54 Buy 15.3 33 1114 HK 7.7 Buy 10.0 30 2238 HK 6.52 Underperform 6.8 (4) Year end Dec Dec Dec Dec PER (x) 2011E 2012E 7.9 6.9 8.1 6.4 18.4 13.5 7.9 7.2 EPS growth (% YoY) 2010 2011E 2012E 75.7 (0.2) 15.1 164.9 17.5 26.6 n.a. 33.9 35.9 69.8 (26.9) 9.6 PBR (x) 2010 2011E 2.5 1.8 2.4 1.5 5.5 3.9 1.4 1.2 ROE (%) 2010 2011E 33.9 26.0 30.9 24.9 22.4 23.9 25.3 16.0 Yield (% p.a.) 2010 2011E 1.6 0 2.5 1.1 0 0 2.2 2.0
2010 8.1 11.4 30.6 6.5
- 26 -

3 January 2012
China: passenger yield growth

YoY (%) 25 15
Aviation Neutral
Kelvin Lau (852) 2848 4467 (kelvin.lau@hk.daiwacm.com)
5 (5) (15) (25)
1H04
2H04
1H05
2H05
1H06
2H06
1H07
2H07
1H08
2H08
1H09
2H09
1H10
2H10 2H10

Weak PLF and yields
During the financial crisis from 2008-09, revenue passenger kilometre (RPK) growth for Chinas aviation industry remained positive at 3-17%, while passenger load factors (PLF) declined slightly, by an average of 1.9pp YoY for 2008 and rose by an average of 1.8pp YoY for 2009. Overall yields (yield per revenue tonne kilometre [RTK]) declined by 3% YoY for 2008 and more sharply by 12% YoY for 2009, which was the largest YoY decline since 1998.
China: RPK growth, PLF change, and yield per RTK growth (2008-09)
2008 2009
Source: CAAC
Domestic
International
Source: Companies, compiled by Daiwa Note: Aggregated for Air China, China Southern Airlines, and China Eastern Airlines
Sharp decline in airfreight

In terms of airfreight volume, the PRC airlines recorded YoY declines from June 2008 to July 2009. Compared with passenger traffic, the decline was much sharper, with revenue freight tonne kilometres (RFTK) declining by 2-44% YoY and the cargo load factor (CLF) dropping by 2-15pp YoY. However, the rises in both these metrics were significant in 2010, when cargo demand was boosted by rush orders from retailers.
China: RFTK growth vs. CLF changes
YoY (%) 95 75 55 35 15 (5) (25) (45) YoY (pp.) 30 20 10 0 (10) (20) (30)
RPK (YoY%) 3.3 17.1
PLF (YoY pp) (1.9) 1.8
Yield per RTK (YoY %) (2.7) (11.7)
The domestic market was more resilient than the international market, in terms of both RPK and PLF. For the PRC airlines, domestic RPK fell by 2-18% YoY during a short period of time from May-September 2008. International RPK dropped by 3-24% YoY for a much longer period of time, from May 2008-June 2009.
China: RPK growth vs. PLF changes
YoY (%) 45 35 25 15 5 (5) (15) (25) YoY (pp.) 15 10 5 0 (5) (10) (15)
Sep-08
Nov-08
Sep-09
May-08
RFTK domestic (LHS) CLF domestic (RHS)
May-09
RFTK international (LHS) CLF international (RHS)
China: cargo yield growth

YoY (%) 30 20 10 0 (10) (20) (30) (40)
Jul-08
May-08
May-09
Jan-08
Mar-08
Jan-09
Mar-09
Jul-09
Nov-08
RPK domestic (LHS) PLF domestic (RHS)
RPK international (LHS) PLF international (RHS)
Nov-09
Sep-09
Sep-08
1H04
2H04
1H05
2H05
1H06
2H06
1H07
2H07
1H08
2H08
1H09
2H09
1H10
Nov-09 1H11
Jul-08
Jan-08
Mar-08
Jan-09
- 27 -
Mar-09
Jul-09
1H11

3 January 2012
High volatility in jet-fuel price

Due to expectations of strong demand, the US Dollar weakening, and increasing speculation, the jet-fuel price rose from US$110/bbl on 2 January 2008 to a peak of US$182/bbl on 3 July 2008. However, as investors saw the chances of a financial crisis, crude-oil prices and jet-fuel prices fell significantly in 2H11.
Jet fuel, WTI, and Brent price movements from 2008-09
(US$/bbl) 180
3) Deregulation of fares. From 2008-09, the government allowed the airlines to adjust premium-class fares more freely. As a result, the PRC airlines raised their premium-class fares by an average of 53%. 4) Greater autonomy in raising fuel surcharge. In 2009, the government allowed the airlines to adjust domestic fuel surcharges automatically, based on changes in the domestic jet-fuel price. This improved the effectiveness of fuel surcharges in offsetting any jet-fuel price rises. 5) Cut in commissions. The Big 3 have been cutting commissions to travel agents since mid-2010. This will likely help to improve their margins over the long term. 6) Tax benefits. The PRC airlines have been exempted from paying a business tax on international traffic since 2010.
130
80
30
Nov-08
May-08
May-09
Nov-09
Sep-08
Sep-09
Jul-08
Jan-08
Mar-08
Jan-09
Mar-09
Jul-09
Jet fuel
Source: Bloomberg
Brent
WTI
Where are we now?

Strong domestic PLFs, but starting to weaken
For the January-November 2011 period, the domestic RPK of the Big 3 PRC airlines (AC, CEA, and CSA) increased by 6.8% YoY. Due to limited capacity expansion in the domestic market and strong consumer confidence, the Big 3 airlines recorded 2.6pp YoY increases in their domestic PLFs for the period. However, we see signs of weakening in SeptemberOctober data. There was a slight rebound in November due to the low base last year.
Domestic RPK growth for the Big 3 airlines during 2011
YoY (%) 20 18 16 14 12 10 8 6 4 2 0
Losses magnified by one-offs

The losses for the airlines were magnified by fuel hedging in 2008. Air China (AC) and China Eastern Airlines (CEA) recorded respective fuel-hedging losses of Rmb7.9bn and Rmb6.3bn for the year. Most of them were mark-to-market losses on their outstanding fuelhedging contracts, which involved selling puts at higher prices than the WTI crude-oil price of US$44.6/bbl. In addition, China Southern Airlines (CSA) and CEA had impairment losses, of Rmb1.9bn and 3.0bn respectively, due to the declining value of their aircraft, which were for sale at that time.
Towards improved profitability

Due to the huge losses recorded by the industry from 2008-09, the PRC Government introduced measures to help improve the industrys profitability over the long term. 1) Capital injection. The government injected a total of Rmb33bn into the Big 3 airlines, which helped to reduce their interest expenses by 19-36% in 2010 compared with 2008. 2) Synergy value from M&A and alliances. In the period from 2008-09, AC acquired Shenzhen Airlines, while CEA acquired Shanghai Airlines. In addition, AC joined Star alliance, and CSA and CEA joined SkyTeam. We expect the synergy value of these moves to become more apparent in the coming years.
Feb-11
Aug-11
Sep-11
AC
Source: Companies
May-11
CSA
CEA
- 28 -
Nov-11
Apr-11
Jul-11
Jan-11
Mar-11
Jun-11
Oct-11

3 January 2012
Domestic PLF changes for the Big 3 airlines during 2011

YoY (pp) 9 7 5 3 1 (1) (3)

Traffic should weaken, but not sharply
Daiwas economist for Greater China, Mingchun Sun, forecasts Mainland GDP growth to slow to 8.3% YoY in 2012 from 9.2% YoY for 2011. This is not as sharp as the slowdown from 2008-09, when GDP growth fell from 14.2% YoY in 2007 to 9.6% YoY in 2008, and 9.2% YoY in 2009. According to our regression analysis, every 1% YoY increase in GDP sees RPK rising by 2% YoY. We therefore expect the slowdown in GDP growth to lead to weakened aviation traffic demand in 2012. However, we do not expect the situation to be as bad as from 2008-09, given the milder decline in GDP growth for 2012.
China GDP growth vs. RPK growth
YoY (%) 20 18 16 14 12 10 8 6 4 2 0 YoY (%) 45 35 25 15 5 (5) (15)
Feb-11
Aug-11
Sep-11
AC
Source: Companies
May-11
CSA
CEA
Weak international traffic due to one-offs

The profitability of the international network remains weak, due mainly to the slow recovery in traffic from the US market, the Europe debt crisis, the earthquake in Japan, and the political uncertainty in the Middle East. International RPK for the Big 3 airlines increased by 16% YoY for January-November 2011 due to an aggressive rise in capacity of 17% YoY. As a result, the international PLF for the period fell by 1pp YoY to 77%.
International RPK changes of the Big 3 during 2011
YoY (%) 60 50 40 30 20 10 0
Nov-11
Apr-11
Jul-11
Jan-11
Mar-11
Jun-11
Oct-11
GDP (LHS) RPK (RHS)

Source: CEIC, CAAC, Daiwa forecasts
GDP forecasts RPK forecasts
Better profitability in 2012 than 2008-09

As a result of the supportive policies and reforms mentioned earlier, we expect the long-term profitability of the airlines to be enhanced. In addition, the PRC airlines have much smaller hedging positions now than in 2008-09. We therefore believe the net profits (on an aggregate basis) of the Big 3 will decline in 2012, but not make the huge losses seen in 2008-09.
Jul-11 Jan-11 May-11 Feb-11 Mar-11 Jun-11 Aug-11 Sep-11 Oct-11 Nov-11 Apr-11
AC
Source: Companies
CSA
CEA
International PLF change of the Big 3 during 2011

YoY (pp) 9 6 3 0 (3) (6) (9)
Domestic PLF should have peaked

As mentioned, we saw initial signs of weakening in the PLF in October numbers. For 2012, we forecast the domestic PLF to decline by 1pp YoY and the domestic yield to drop by 2-3% YoY, due to continued falls in the fuel surcharge, competition from high-speed trains, and the risk of the economy slowing more than in 2011.
Jul-11
Jan-11
May-11
Feb-11
Mar-11
Jun-11
Aug-11
Sep-11
Oct-11
AC
Source: Companies
CSA
CEA
Nov-11
Apr-11
- 29 -
2011E
1987
1989
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1993
1995
1997
1999
2001
2003
2005
2007
2009

3 January 2012
International PLFs should bottom out

The profitability of the international network was weak in 2011 due to the slowdown in the global economy, the events in the Middle East and one-off events in Japan. For 2012, we expect PRC outbound traffic to continue to grow at a faster pace than domestic traffic. We forecast the international RPK to increase by 10-11% YoY compared with 6-7% YoY for 2011. We expect the international PLF and yield to be flat YoY for 2012.
Valuation and catalysts

Based on our 2012 forecasts, the stock is trading at a PBR of 0.9x and EV/EBITDAR of 4.6x. These levels are well below its past-five-year averages of 1.9x and 11.4x, respectively, and the respective mid-cycle (2005-06) PBR of 1.5x and EV/EBITDAR of 5.7x. We would expect share-price catalysts to be a recovery in international traffic, a rebound in the cargo market, and consistent growth in premium traffic.
AC: 12-month-forward PBR and EV/EBITDAR
PBR (x) 1.4 1.5 2.5 1.5 1.6 2.4 1.1 0.9 1.9 1.8 EV/EBITDAR (x) 5.5 5.8 19.4 17.3 6.6 7.7 4.8 4.6 11.4 10.4
International players should be best-placed

Given that we expect the YoY growth in international traffic to be better than that for domestic, we prefer the airlines with greater international exposure, especially AC, which has a profitable international network.
Thematic pick: Air China

Look for a rebound in international traffic
Our top pick among other PRC airlines is AC, which derives 30% of its revenue from international routes (CSA 20%, and CEA 30%). Compared with CSA and CEA, ACs international network is much more profitable. The main profitable routes include those to Japan, Korea, and the US. European routes have not performed as well so far this year. Regional routes such as those to and from Hong Kong and Taiwan also remain profitable. We expect the stock to be rerated by the market in 2012.
Aviation: target prices
Company Air China Limited China Southern Airlines Co Ltd China Eastern Airlines Corp Ltd Beijing Capital International Airport Co Ltd TravelSky Technology LTD
2005 2006 2007 2008 2009 2010 Current 2011E Current 2012E Past five-year average Past 10-year average
Source: Bloomberg, Thomson Reuters, Daiwa forecasts
Bloomberg code 753 HK 1055 HK 670 HK 694 HK 696 HK
Share price 19-Dec-11 (local curr.) 5.33 3.9 2.72 3.82 3.75
Six-month target price (local curr.) 7.50 3.90 2.50 4.40 5.30
Upside/downside potential (%) 40.7 0.0 (8.1) 15.2 41.3
2012E PER (x) 0.9 0.8 1.0
Valuation basis PBR of 1.1x on our FY12 forecasts PBR of 0.8x on our FY12 forecasts PBR of 0.8x on our FY12 forecasts
0.9 DCF-based 1.2 DCF-based
Aviation: valuation summary

Company Air China Limited China Southern Airlines Co Ltd China Eastern Airlines Corp Ltd PBR EV/EBITDAR Six-month (x) (x) Bloomberg Share price target price +/- Year end code 19-Dec-11 Rating (local curr.) (%) 2010 2011E 2012E 2013E 2010 2011E 2012E 2013E 753 HK 5.33 Buy 7.50 40.7 Dec 1.3 1.1 0.9 0.7 4.6 4.8 4.6 4.1 1055 HK 3.9 Hold 3.90 0.0 Dec 1.2 0.9 0.8 0.7 4.3 4.5 4.9 4.6 670 HK 2.72 Sell 2.50 (8.1) Dec 1.7 1.2 1.0 0.8 5.1 4.9 5.2 4.7 3.82 3.75 Buy Buy 4.40 15.2 5.30 41.3 Dec Dec 1.0 1.4 0.9 1.3 0.9 1.2 0.8 10.3 1.0 4.7 8.2 3.9 7.9 3.7 2010 33.0 20.4 39.6 ROE (%) 2011E 2012E 2013E 18.0 17.4 15.7 16.6 10.9 10.8 21.7 12.5 13.6 7.4 14.5 8.5 14.6 9.8 14.7
Beijing Capital International Airport Co Ltd 694 HK TravelSky Technology LTD 696 HK
7.0 4.5 2.9 14.1
- 30 -

3 January 2012
China: growth in LGFV liabilities

(%) 70 60 61.92 48.2
Banks Positive
Grace Wu (852) 2532 4383 (grace.wu@hk.daiwacm.com) Queenie Poon (852) 2532 4381 (queenie.poon@hk.daiwacm.com)
50 40 30 20 10 0 1997 24.82
26.52 33.32 23.48 18.86
1998
2002
2007
2008
2009
2010

Tightening followed by lending surge in 2009
The slowdown in 2008 was driven by tight credit in 1H08, leading to SME failures as high inflation and wage increases eroded profit margins alongside weakening orders. This is similar to the situation today, although informal lending rates are said to be higher than those in 2008 despite benchmark interest rates being lower than the 2008 levels. From 2008-09, the governments monetary policy moved from tightening mode to expansionary mode, prompted by the Rmb4tn stimulus package in 2009 to maintain growth in the economy in light of the global financial crisis. This saw new loans surge to Rmb9.6tn for 2009 from Rmb4.9tn in 2008, and raised concerns about asset quality, as rapid credit expansion is often followed by asset deterioration in subsequent years. This was particularly true for China in 2009, as the amount of local government financing vehicle (LGFV) liabilities also rose sharply during 2009.
China: annual new loans
(Rmb tn) 12 10 8 6 4 2 0 2004
Source: CEIC, Daiwa
Source: National Audit Office Note: 2002 growth rate is an average annual growth rate for 1998-2002; 2007 growth rate is an average annual growth rate for 2002-07
As part of the governments stimulus, the PBoC cut interest rates five times, by a total of 216bps, from August to December 2008. This resulted in a 75bp YoY NIM contraction for the Banks Sector in 2009. Despite the NIM contraction, sector EPS still grew by 16.5% YoY for 2009, as the stimulus quickly turned the economy around, and while banks saw an increase in bad debts, the situation was contained with the release of new lending into the system, thus preventing a credit crisis.
China: lending and deposit rates
(%) 8 7 6 5 4 3 2 1 0
Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11
Demand deposits
Source: PBoC, CEIC
1 Year deposits
1 Year loans
Banks: net-interest margin

(%) 3.2 3.0 2.8 2.6 2.4
2005 2006 2007 2008 2009 2010
2.2 2.0 2004 2005 2006 2007 2008 2009 2010

Source: Companies, Daiwa
- 31 -

3 January 2012
Where are we now?

Rising credit costs the biggest challenge
From an inflationary standpoint, there is now less room for interest-rate cuts, suggesting banks are unlikely to experience significant net-interest margin (NIM) contraction as they did during the previous cycle. That said, the sector faces greater asset-quality risks now given the surge in lending during 2009, particularly related to local government lending and real-estate exposure, with the continued rise in property prices, as well as the rapid pace of off-balance sheet growth in recent years. Having said this, the recent clampdown by regulators has already resulted in a slowdown of off-balance sheet transactions in 3Q11, suggesting to us that the regulators are taking early and concrete actions to contain off-balance sheet growth.
China: total social financing
(Rmb bn) 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 2002
Source: CEIC
Banks: capital-adequacy ratios

(%) 13 12 11 10 9 8 7 6
Jun-08 Jun-09 Jun-10 Mar-08 Mar-09 Mar-10 Sep-10 Sep-09 Sep-08 Dec-07 Dec-08 Dec-09 Dec-10 Mar-11 Jun-11
Core CAR
Source: CEIC
Total CAR
Commercial banks: provision-coverage ratio

(%) 280 260 240 220 200 180 160 140 120 100
Oct-09
Jun-09
Jun-10
Oct-10
Feb-09
Feb-10
Dec-08
Aug-09
Dec-09
Aug-10
Dec-10
Feb-11
Jun-11
Source: CEIC
Banks: fee income as a % of total operating income

2003 2004 2005 2006 2007 2008 2009 2010 9M10 9M11
(%) 20 18 16 14 12 10 8 6 4 2004
Source: Companies
Bank-loan financing as a % of total social financing

100% 95% 90% 85% 80% 75% 70% 65% 60% 55% 50%
1Q11 1H11 2002 2003 2004 2005 2006 2007 2008 2009 2010 9M11
2005
2006
2007
2008
2009
2010
Source: CEIC
The saving grace is that increased regulatory requirements have lifted both capital and provisioning levels across the sector. In addition, fee income now plays a bigger role in earnings for the banks, thus broadening their revenue streams.
Another key difference now compared with 2008 is the RRR level. With the RRR standing at an all-time high currently, there is considerable room for regulators to lower it as a means to fine tune monetary policy, instead of cutting interest rates. The PBOC already announced a 50bps RRR cut effective 5 December, and we expect another 200bps cut in the RRR by 1H12.
- 32 -
Aug-11
Apr-09
Apr-10
Apr-11

3 January 2012
China: RRR
(%) 25 20 15 10 5 0
Banks: capital-adequacy ratios (3Q11)

(%) ICBC CCB BoC ABC BoCom CMB Citic Minsheng CQRB
Source: Companies, HKEJ
Core CAR 10.03 10.57 9.92 9.36 9.24 8.10 10.43 7.98 14.50
Total CAR 12.51 12.58 12.84 11.85 11.89 11.39 12.83 10.94 15.75
Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11
Banks: demand deposits as a % of total and LDR (3Q11)

(%) ICBC CCB BOC (domestic Rmb deposits only) ABC BoCom CMB Citic Minsheng CQRB
Source: Companies Note: As of 1H11
RRR
Source: CEIC
Larger banks
Smaller banks

Normalising credit costs
While we expect NPLs and credit costs to normalise from an exceptionally low level currently, we believe the chance of a major credit crisis in 2012 is unlikely, as most LGFV loans are due to be repaid over the next few years and low loan-to-value ratios in real-estate lending provide a reasonable cushion against bad debts. In our view, the high level of provisioning coverage would also help to smooth out earnings in the event of moderate asset deterioration. Although interest-rate deregulation is likely to raise funding costs and lower NIMs for the sector, this is likely to be a multi-year process and unlikely to have a major impact on NIMs in 2012. Having said that, we believe the deposit franchise will be of increasing important to the banks, as slower loan growth means more emphasis on cost management and on crossselling capabilities. Hence, we believe the deposit franchise will be an increasingly important differentiator of earnings in the next few years.
Demand deposits (% of total deposits) 49.9 47.2 44.8 56.7 47.7 52.7 46.0* 42.6* 39.7
Loan-to-deposit ratio 62.6 65.1 71.7 56.6 72.8 76.5 74.0 74.3 60.6
PRC banks: provisioning levels (3Q11)

(%) ICBC CCB BoC ABC BoCom CMB Citic Minsheng CQRB
Source: Companies
Provision coverage (as a % of NPLs) 272.7 248.6 223.0 237.9 228.9 366.5 250.3 355.4 206.9
Loan-loss reserve (as a % of loans) 2.48 2.53 2.21 3.81 2.15 2.16 1.49 2.19 3.71
Thematic pick: ICBC

We believe ICBC scores well on all fronts. It has one of the strongest capital positions in the sector, as well as one of the lowest loan-to-deposit ratios. The company also has a relatively high proportion of low-cost demand deposits, giving it a funding-cost advantage. As the largest bank in China, its vast customer base provides abundant cross-selling opportunities. Moreover, we believe ICBC has the tightest loan discipline, with loans growing at a slower pace than the industry average from 2005-10. In addition, we see the companys overdue loan recognition policy as the most prudent in the sector. Its solid foundations should help mitigate the effect from potential NPL headwinds, in our view.
Company-by-company impact
With tighter capital and provisioning requirements, as well as potential interest-rate deregulation, we believe there will be a greater emphasis on risk-weighted returns for banks. That is, the banks need to achieve greater returns for the same amount of risk-weighted capital, while achieving sufficient and profitable growth for capital replenishment. This also means banks with strong capital and lower loan-to-deposit ratios are likely to see greater room for market-share gains, and should be more resilient to deposit competition. This implies that those with higher capital levels, stronger deposit franchises, and greater cross-selling capabilities will stand out.
- 33 -

3 January 2012
ICBC: loan growth vs. sector (YoY, %)

ICBC Sector 2004 9.0 12.1 2005 (11.3) 9.3 2006 10.4 15.7 2007 12.2 16.1 2008 12.2 15.9 2009 25.3 31.7 2010 9M11 (YTD) 18.5 11.9 19.9 10.4
Source: Company, CEIC

Our six-month SOTP-based target price for ICBC is HK$5.85 (implying a 2012E PBR of 1.6x), based on a Gordon Growth Model-based fundamental target price of HK$6.80 (1.8x 2012E PBR) and a 30% haircut on LGFV loans (implied HK$0.95/share). We believe the company will continue to see more resilient deposit trends than its peers, while its strong capital position is unlikely to trigger any equity-raising in 2012.
Banks: target prices
Company ABC Bloomberg code 1288 HK Share price 19-Dec-11 (HK$) 3.20 Six-month Upside/downside target price potential (HK$) (%) 4.40 37.5
The downside risks for ICBC include a further selldown by Goldman Sachs, which has a 2.5% stake (or 8.78bn H shares), after three disposals of ICBC shares in June 2009, September 2010, and November 2011. ICBC has been expanding overseas over the past few years, and the execution of its overseas M&A strategy may pose a greater risk to the company, in our view.
BoCom ICBC CMB
3328 HK 1398 HK 3968 HK
5.32 4.60 15.36
6.80 5.85 19.40
27.8 27.2 26.3
CCB BoC
939 HK 3988 HK
5.44 2.81
6.25 2.95
14.9 5.0
Citic Minsheng
998 HK 1988 HK
4.25 6.40
4.40 6.00
3.5 (6.3)
2012E PER (x) Valuation basis 5.6 SOTP-based six-month target price of HK$4.4 (implied 2012E PBR of 1.65x) is based on a fundamental target price of HK$5 (1.8x 2012E PBR) and a 30% haircut on LGFV loans (implied HK$0.6/share). Key risks: policy changes that may lead to slower rural lending or less policy support; county loans may have higher NPLs 5.2 SOTP-based six-month target price of HK$6.8 is based on a fundamental target price of HK$8.3 (1.3x 2012E PBR) and a 30% haircut on LGFV loans (implied HK$1.5/share). Key risk: further capital-raising 5.7 SOTP-based six-month target price of HK$5.85 (implying a 2012E PBR of 1.6x) is based on a fundamental target price of HK$6.8 (1.8x 2012E PBR) and a 30% haircut on LGFV loans (implied HK$0.95/share). Key risk: execution of overseas strategy 6.4 SOTP-based six-month target price of HK$19.4 (implied 2012E PBR of 1.8x) is based on a fundamental target price of HK$20.7 (1.9x 2012E PBR) and a 30% haircut on LGFV loans (implied HK$1.3/share). Key risk: execution of its targeted Rmb35bn A+H share rights issues 6.3 SOTP-based six-month target price of HK$6.25 is based on a fundamental target price of HK$7.10 (1.6x 2012E PBR) and a 30% haircut on LGFV loans (implied HK$0.85/share). Key risk: further disposals by key foreign stakeholders 5.3 SOTP-based six-month target price of HK$2.95 is based on a fundamental target price of HK$3.6 (1.1x 2012E PBR) and a 30% haircut on LGFV loans (implied HK$0.65/share). Key downside risk: global economic slowdown given the companys high overseas exposure. Key upside catalyst: significant growth from offshore Renminbi developments 5.8 SOTP-based six-month target price of HK$4.4 is based on a fundamental target price of HK$5.7 (1.15x 2012E PBR) and a 30% haircut on LGFV loans (implied HK$1.3/share). Key downside risk: further RRR hikes. Key upside catalyst: significant loosening in China 6.4 SOTP-based six-month target price of HK$6, based on a fundamental target price of HK$7.9 (1.3x 2012E PBR) and a 30% haircut on LGFV loans (implied HK$1.9/share). Key downside risk: inadequate long-term capital for its aggressive business-growth strategy. Key upside catalyst: resilient asset quality of micro-financing loans and lowerthan-expected credit costs
Banks: valuation summary

Company ABC BoCom ICBC CMB CCB BoC Citic Minsheng Bloomberg code 1288 HK 3328 HK 1398 HK 3968 HK 939 HK 3988 HK 998 HK 1988 HK Share price 19-Dec-11 (HK$) 3.20 5.32 4.60 15.36 5.44 2.81 4.25 6.40 Rating Outperform Outperform Outperform Outperform Outperform Hold Hold Hold Six-month target price (HK$) 4.40 6.80 5.85 19.40 6.25 2.95 4.40 6.00 +/- Year (%) end 37.5 Dec 27.8 Dec 27.2 Dec 26.3 Dec 14.9 Dec 5.0 Dec 3.5 Dec (6.3) Dec 2010 7.9 5.9 7.7 10.2 7.9 5.8 6.3 7.9 PER (x) 2011E 2012E 6.3 5.6 5.6 5.2 6.2 5.7 7.8 6.4 6.9 6.3 5.3 5.3 5.0 5.8 5.2 6.4 EPS growth (% YoY) 2010 2011E 2012E 32.3 25.2 11.6 18.8 5.2 8.5 28.2 25.6 8.8 29.1 30.0 22.4 22.5 15.1 8.4 28.3 9.3 0.5 51.1 25.7 (13.2) 28.3 52.9 (19.2) PBR (x) 2010 2011E 1.56 1.35 1.09 0.97 1.56 1.41 2.01 1.36 1.59 1.39 1.01 0.92 1.12 0.95 1.34 1.11 ROE (%) 2010 2011E 21.4 23.0 20.2 19.0 22.1 24.1 22.7 21.9 21.5 21.6 18.0 17.7 19.3 20.2 18.3 22.7 Yield (% p.a.) 2010 2011E 6.6 6.4 2.8 3.5 4.9 6.3 2.3 2.2 4.8 5.7 6.4 7.4 4.5 1.9 2.7
Source: Companies, Bloomberg, Daiwa forecasts
- 34 -

3 January 2012
China Cement Sector: YoY changes in earnings, sales volume and unit gross profit for 2008 and 2009
YoY chg (%) CR Cement Shanshui CNBM WCC Conch Sinoma Total/weighted average
Source: Companies
Cement Positive
Felix Lam (852) 2532 4341 (felix.lam@hk.daiwacm.com)
Net income 2008 2009 111 33 154 30 66 56 64 129 5 34 16 27 34 38
Sales volume 2008 2009 42 32 41 24 206 44 44 47 18 16 45 32 55 28
Unit gross profit 2008 2009 (18) 26 46 (9) 1 (2) 23 40 (13) 2 (11) 27 (3) 1

Rapidly slowing GDP growth drove down demand growth for cement
In 2008, China announced a series of measures to try to cool the economy and domestic property market. The situation was made worse by the emergence of US sub-prime mortgage issues and the collapse of Lehman Brothers. Macro headwinds locally and globally dragged down GDP growth from 11.3% YoY for 1Q08 to below 8% YoY for both 4Q08 and 1Q09. As such, Chinas cement demand growth decelerated to 2% YoY for 2008, from 11% YoY for 2007 and 15% YoY for 2006.
Where are we now?

China and the global economy are facing big challenges, again...
High inflation, bank credit tightening, and conflicts between the government and property companies over the curbing of private-residential property prices are challenges facing China now. Growth in infrastructure investment decelerated sharply from March to August 2011, and the outlook for property investment has become increasingly unclear for 2012. Both segments are major users of cement, accounting for over 70% of Chinas consumption.
China: monthly infrastructure, real-estate and urban FAI
(% ) 60 50 40 30 20 10 0 (10)
Overcapacity and a fragmented market weighed on cement price

Net capacity growth accelerated to 10% YoY for 2008, from 7% YoY for 2007, as increases in new dryprocessing capacity outpaced closures of obsolete capacity. More importantly, the cement industry remained fairly fragmented, showing no clear signs of consolidation. The top-10 producers accounted for less than 24% of the countrys total cement output in 2008. As capacity growth exceeded demand growth, and there was no supply discipline, cement prices and unit gross profit contracted.
Jul-10
May-10
May-11
Mar-10
Jan-11
Jan-10
Sep-10
Mar-11
Jul-11
Sep-11
Nov-10
Infrastructure
Source: CEIC
Real Estate
Total urban
Share prices fell significantly despite good earnings growth

Despite the imbalance between demand and supply and a very competitive industry landscape, big companies managed to post good earnings growth due to rapid increases in sales volumes. That said, investors overlooked the demand prospects for cement and thus reduced their positions heavily in the leading cement producers. The share prices of Anhui Conch and CNBM fell by 80% and 94%, respectively, from peak to trough in 2008.
...but more co-operation and discipline within the industry

While we see similarities in the macroeconomic situation between 2008 and 2011, the cement sectors landscape has been different this year compared with 2008. What has been important in 2011 has been the emergence of supply discipline as consolidation finally plays out. The governments suspension of approvals to build new production lines is helping consolidation. The combined market share of the top10 producers should approach 30% by the end of this year, in our view.
- 35 -
Nov-11

3 January 2012
China: rising market share of top-10 producers by cement production volume

(%) 30 28 26 24 22 20 2008
Source: Digital Cement, Daiwa
China Cement Sector: industry net income and margin (10M11)

(Rmb bn) 80 70 60 50 40 30 20 10 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 10M11 Net profit Net profit margin (RHS) (% ) 12 10 8 6 4 2 0
2009
2010
9M11
Source: Digital Cement, Daiwa
Generally, the east, south-central and northeast regions have a better demand/supply balance than the rest of China. This is because these regions have the lowest capacity-growth potential, while a lot of new approved capacity that has yet to be completed is in the hands of the major cement companies. There are more incentives for cement producers in these regions to maintain supply discipline to protect prices and profit margins than to compete fiercely on cement prices for market share. With capacity growing slower than demand for 2011E, selling prices have held up fairly well year-to-date (and are still substantially higher than in 2008-10), except in some provinces in the west of China, where there is still plenty of new capacity coming onto the market.

Overall, we believe the China Cement Sector has changed structurally, with the underlying fundamentals for the leading cement companies stronger now than they were in 2008. While China is unlikely to launch another big stimulus package to help the economy, and cement demand growth is slowing, we expect the cement companies earnings to at least remain flat on sustainable selling prices and profit margins for 2012E. We also see upside potential to our earnings forecasts, due to acquisitions.
Cement demand has not peaked yet

We do not expect all of the demand drivers for cement to fall apart. Our analysis suggests that increasing demand for infrastructure aimed at improving water resources (eg, water supply and conservation) and urban development should offset slowing demand for cement in other areas. We forecast demand growth of 7.2% YoY for 2012.
China: changes in cement demand
2,350 (Tonnes m) 2,400 74 25 18 (25) 2,220 2,300 38 80 17 2,200 65 (48) 35 2,071 101 8 2,100 2,000 1,858 82 (50) 46 26 1,900 1,800 1,700
Sector has outperformed the market on expectations of record earnings for 2011
While the share prices of the cement companies have declined by an average of 44% from their peaks in the middle of July, the sector has generally outperformed the MSCI China Index by an average of 6% YTD. We attribute this to investors expecting record 2011 earnings for the sector and the leading cement producers, thanks mainly to higher cement prices.
China Cement Sector: YTD average share-price performances of cement stocks we cover vs. that of MSCI China Index
Performance (1/Jan/11 =100) 160 140 120 100 80 60 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec China Cement* MSCI China
2010
Railway
Water
Others
Others
Water
Water
Others
2011E
2012E
Private residential
Private residential
Private residential
Other properties
Other properties
Rural development
Rural development
Other properties
Source: Bloomberg, Daiwa *Average share performance of the China cement companies under Daiwa coverage
- 36 -
Rural development
2013E

3 January 2012
Excess capacity should shrink and supply discipline should hold

We do not expect the government to approve the construction of any new clinker production lines in 1H12, and believe that it will only approve some expansion plans in 2H12. As a result, we forecast a total of 100mtpa of new clinker capacity to be added in 2012. On the other hand, we expect the government to continue closing vertical kilns and obsolete production lines. Overall, we forecast net cement-production capacity to increase by only 0.6% YoY for 2013, slower than demand growth. We understand that it is not easy for the cement companies to increase selling prices when demand growth weakens and the market still has excess production capacity. However, supply discipline should enable prices to at least hold up in some regions in China, even though implementing such discipline has not been smooth. With an acceleration in industry consolidation, moderate demand growth and shrinking excess capacity, we see reasons for supply discipline to hold up next year.
China: cement demand and supply
2008 Volume (m tonnes) Production Imports Exports Apparent demand Production capacity YoY chg (%) Production Imports Exports Apparent demand Production capacity 1,388 1 (13) 1,375 1,743 2009 1,629 0 (8) 1,620 1,964 2010 1,868 1 (10) 1,858 2,226 2011E 2,079 1 (9) 2,071 2,367 2012E 2,228 1 (9) 2,220 2,419 2013E 2,356 1 (9) 2,348 2,434
(by 2012-13E), prices in these regions have risen to new levels (higher than in the past five years), which we see as being largely sustainable in the coming years until cement demand starts falling off rapidly (maybe after 2015). In the southwest and northwest, cement prices are likely to face more downside risks in 2012, in our view, as many new cement production lines will commence, leading to overcapacity. It will probably be a while before demand largely matches available capacity.
China: cement prices by region
(Rmb/t) 500 450 400 350 300 250
2011E
2012E
National North Northwest

Source: Digital Cement, Daiwa forecasts
East Northeast
South Central Southwest
Flat earnings outlook
5.2 5.0 (12.9) 5.4 18.6
17.3 (36.4) (35.9) 17.8 12.7
14.7 128.6 17.8 14.7 13.4
11.3 (15.0) (10.0) 11.5 6.3
7.2 7.2 2.2
5.8 5.8 0.6
We expect the cement companies earnings to be flat YoY for 2012, as sales-volume increases may not be enough to fully offset declines in selling prices and unit gross profit. The difference between 2008-09 and 2011-12 is that earnings growth could be less exciting for 2012 given the high base in 2011 (we forecast the aggregate earnings of the companies we cover to more than double YoY for 2011).
China cement: YoY changes in earnings, sales volume and unit gross profit (2011E and 2012E)
% change CR Cement Shanshui CNBM WCC Conch Sinoma Total/weighted average
Source: Digital Cement, Daiwa forecasts
China Cement Sector: clinker and cement capacity outlook

Clinker production capacity (tpa m) New dry processing Vertical kilns and others Cement production capacity ( tpa m*) YoY chg (%) 2008 1,202 762 440 1,743 18.6 2009 1,354 963 391 1,964 12.7 2010 1,535 1,213 322 2,226 13.4 2011E 1,633 1,373 259 2,367 6.3 2012E 1,669 1,473 195 2,419 2.2 2013E 1,679 1,523 155 2,434 0.6
Source: Digital Cement, Daiwa forecasts *Note: Assuming output ratio of 1 tonne of clinker to 1.45 tonnes of cement
Net income 2011E 2012E 134 17 180 2 141 (15) (30) 16 100 (6) 53 (4) 108 (4)
Sales volume 2011E 2012E 53 39 17 15 17 17 28 34 19 19 29 22 22 20
Unit gross profit 2011E 2012E 23 (8) 91 (7) 89 (12) (26) (8) 58 (17) 9 (17) 55 (14)
Cement prices: less volatile and structurally higher than in previous cycles
While we still expect cement-price volatility in China in 2012, the situation in the south-central, east, north and northeast regions should be better in 2012 than it has been over the past few years, given the emergence of supply discipline, stable demand and ongoing consolidation. With capacity growth coming to an end - 37 -
2013E
2003
2004
2005
2006
2007
2008
2009
2010

3 January 2012
Thematic pick: CR Cement

Still the best in the sector
With its strong management team, high level of support from the parent company, favourable geographical exposure and better earnings-growth prospects than its peers, CR Cement remains our top pick in the China Cement Sector.
CR Cement: earnings and gross and operating margins
(%) 35 30 25 20 15 10 5 0 2006 2007 2008 2009 2010 2011E 2012E 2013E Net income (RHS) Operating profit margin (LHS)
Source: Company, Daiwa forecasts
growth prospects, by virtue of what we see as its sales volume growth and better geographical exposure. It is the largest producer in south China, for which we have a better cement market outlook for 2012 than the other regions in China. For those investors who are sceptical about the cement companies earnings visibility, we see EV/tonne as a good assessment method as asset values are less volatile. CR Cement is trading currently at an EV/tonne of Rmb522 based on our 2012 forecasts, or 16% above the high end of its replacement cost. In our view, this can be justified by: 1) the companys operating efficiency, which contributes to its above-industryaverage unit gross profit, and 2) the upside potential that we see in year-end capacity.
(HK$bn) 7 6 5 4 3 2 1 0 Gross profit margin (LHS)
Risks and catalysts

In our view, the key potential share-price catalysts would include: 1) acquisitions of cement companies with decent capacity (3m tpa or above) in good locations, 2) new projects to construct landmark infrastructure in key markets (Guangdong, Guangxi, Hainan and Fujian Provinces), and 3) positive surprises in the 2011 results. The major risks for CR Cement would be: 1) delays in capacity expansion, 2) infrastructure investment and GDP growth for south China slowing by more than the national average, and 3) use of equity financing as a means to reducing gearing.
Valuation
We value CR Cement on a par (11x 2012E PER) with Anhui Conch, as we believe the two companies are similar in terms of management quality, operating efficiency and unit gross profit. Despite its smaller scale, we believe CR Cement has better 2012 earningsCement: target prices
Company Shanshui CR Cement CNBM WCC Conch
Bloomberg code 691 HK 1313 HK 3323 HK 2233 HK 914 HK
Share price Six-month Upside/downside 19-Dec-11 target price potential 2012E PER (HK$) (HK$) (%) (x) Valuation basis 5.01 9.9 97.6 4.1 Target PER of 8.2x, at 25% discount to Conchs target PER. 5.75 9.45 64.3 6.7 Target PER of 11x, at par with Conchs target PER. 8.74 12.9 47.6 5.6 Target PER of 8.2x, at 25% discount to Conchs target PER. 1.29 1.75 35.6 4.8 Target PER of 6.6x, at 40% discount to Conchs target PER. 22.7 29.5 30.0 8.4 Target PER of 11x, at 10% discount to its average multiple for Oct 08-Oct11
Cement: valuation summary

Company Shanshui CR Cement CNBM WCC Conch Bloomberg code 691 HK 1313 HK 3323 HK 2233 HK 914 HK Share price 19-Dec-11 (HK$) 5.01 5.75 8.74 1.29 22.7 Rating Buy Buy Buy Outperform Outperform Six-month target price (HK$) 9.9 9.45 12.9 1.75 29.5 +/- Year (%) end 97.6 Dec 64.3 Dec 47.6 Dec 35.6 Dec 30.0 Dec 2010 12.1 18.4 12.0 4.1 16.7 PER (x) 2011E 2012E 2013E 4.2 4.1 3.7 7.9 6.7 5.8 4.7 5.6 5.0 5.5 4.8 3.9 7.9 8.4 7.5 2010 7.2 14.3 8.4 4.0 10.8 EV/EBITDA (x) 2011E 2012E 2013E 3.7 3.4 3.2 7.4 5.9 4.6 5.2 5.4 4.7 4.4 3.0 2.1 5.2 5.3 4.4 2010 8.1 1.9 0.4 1.5 1.1 Dividend yield (%) 2011E 2012E 2013E 8.4 8.5 9.4 2.2 2.6 2.8 1.1 0.9 1.0 1.8 2.1 2.6 2.5 2.4 4.0
Source: Companies, Daiwa forecasts
- 38 -

3 January 2012
Consumer
Matt Marsden
Bing Zhou
Both Hong Kong and the Mainland returned to healthy levels of retail sales growth, both close to 20% YoY from 2010. Since then, however, we note that Hong Kong retail sales growth has increasingly outpaced that of the Mainland a development that we think would have eluded most forecasters (including us) back in 2010.
(852) 2848 4963 (matthew.marsden@hk.daiwacm.com) (852) 2773 8782 (bing.zhou@hk.daiwacm.com)
Inflation pushes retail sales

As a rule of thumb, steady inflation contributes to healthy retail sales growth, while cooling inflation has the converse effect. Chinas CPI growth of 6.6% YoY in 2007 was the highest over the past five years, and helped to push retail sales growth, eg, Lianhuas (Not rated) samestore-sales (SSS) growth rose to a record high of 10.5% YoY in 2007. CPI growth fell significantly to 2.5% YoY in 2008 and 0.7% YoY during the global financial crisis in 2008-09. We note that food retailers Lianhua and China Resources Enterprise (Not rated) saw SSS growth decline to a respective 0.2% YoY and 0.3% YoY, in 2008-09.
Supermarket retail SSS growth vs. CPI growth vs. margins
14% 12% 10% 8% 6% 4% 2% 0% 2007 2008 Lianhua Net Margin Lianhua SSS Growth
Source: CEIC, Company Reports

Slowing GDP impacted retail sales growth: HK hit harder than PRC last time around
As GDP growth deteriorated in 2008-09, so did retail sales; Mainland retail sales declined from a steady average monthly YoY growth rate of 22% in 2008 to 12% YoY in February 2009. Mainland retail sales growth did not recover to 2008 levels until Lunar New Year in February 2010, but still achieved healthy 15.5% YoY growth, on an average monthly basis, for the March-December 2009 period. We note that Hong Kong retail sales were much more adversely affected by the 2008-09 global financial crises. The 9M08 YoY monthly average growth rate of 14.1% quickly fell to 0.9% in 4Q08, before turning negative and reaching a trough of -12.7% YoY in February 2009. Hong Kong retail sales continued to struggle over the March-November 2009 period, posting an average monthly decline of -2.0% YoY. But steadily recovered in 4Q09 to reach respectable YoY growth of 16.1% in December 2009.
Hong Kong and Mainland retail sales growth
40% 30% 20% 10% 0% (10%) (20%) Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 HK Retail Sales (YoY%)
Source: Bloomberg
2009
2010
1H11
China CPI Growth CRE RD SSS Growth
Discretionary and staples sold off during GFC; discretionary took longer to recover
As Mainland retail sales and inflation dipped, Hong Kong-listed consumer sector stocks were not spared during the sell-off in the global markets. Through 2008, the consumer discretionary sector progressively underperformed the staples sector as market fears of a slowdown brewed.
PRC Retail Sales (YoY%)
- 39 -

3 January 2012
China consumer discretionary sector PER bands 2006-11
28x 24x 20x 16x 12x
Subsequently, we believe that levels of perceived competitive risk have risen dramatically over the past three years. Note that valuations in the sportswear and department store sub-sectors have fallen significantly: Sportswear is the worst performing sub-sector with stocks losing 53% on average over the past 12months. Companies are posting a bleak outlook with Anta (Not rated) stating that discounting continues across the board at around 27% off the recommended retail price in 4Q11, due to Li Ning (Not rated) and China Dongxiang (Not rated) discounting heavily in an attempt to clear unsold inventory in their distribution channels. Department stores have sold off by 35% on average over the past year. We are seeing declining concessionaire commission rates and waning SSS growth across the sector as increasing competition among modernising department store chains, and new format competition from shopping malls, gives enhanced negotiating power to international brands and increases competition for shoppers.
20-Jan-06
20-Jan-07
20-Jan-08
20-Jan-09
20-Jan-10
20-Jan-11
Source: MSCI China consumer discretionary index consisting of 22 large cap stocks, Bloomberg
Eventually, the consumer discretionary and staples sectors were sold off equally hard during the beginning of the market crash in 4Q08 the MSCI China consumer indices for discretionary and staples both reached a PER of 12x.
China Consumer Staples Sector PER Bands 2006-11
28x 24x 20x 16x 12x
Naturally accident prone, or just unlucky?

Moreover, the consumer sector overall has seen more than its fair share of accidents. Over 2009-11 we have seen: The significant fall in Esprits share price (Not rated), which has declined by 73% over the past year as the brand has lost its soul (source: company report). Bawangs (Not rated) 66% decline over the past year after the company was falsely accused of using harmful chemicals in its shampoo (Bawangs ingredients have since been proven to be in the clean). Corporate governance issues at Chaoda (Not rated). Chaoda has lost 82% over the past year, making this the worst performing stock in the entire consumer sector. Trading in the stock is currently suspended, and we have no visibility as to when it will resume. A contaminated pig scandal at China Yurun (Not rated). The stock has lost 61% over the past year. Incidents like these may help to explain investors increasingly risk-averse attitude towards the sector we note that large, liquid consumer staple stocks with a good track record of delivery have increased their valuation premiums throughout 2011. We see that the valuation spread between the consumer staples and discretionary is approaching its past-five-year high.
20-Jan-06
20-Jan-07
20-Jan-08
20-Jan-09
20-Jan-10
20-Jan-11
Source: MSCI China consumer staples index consisting of 10 large cap stocks, Bloomberg
However, during the market recovery phase, the valuations for consumer staples recovered faster than those for discretionary, recovering to 20x PER by mid2009. The MSCI China Discretionary Index lagged the MSCI China Staples Index by around six months, reaching 20x PER by the end of 2009.
Where are we now?

More choice and more competition
The consumer sector has changed since 2008. Firstly, investors have more choice: 28 of the 132 companies that we track in the Hong Kong-listed consumer sector were listed in 2009-11, including a new luxury goods sector; Prada (Not rated), Samsonite (Not rated) and Chow Tai Fook (Not rated).
- 40 -

3 January 2012
Discretionary vs Staples indices 2006-11

Rebased to 100 250 200 150 100 50 Jan-06
I.T (Not rated) management states that 3Q FY12 (Sept. Nov. 2011) SSS growth in Hong Kong has remained very healthy in the high teens, but this has slowed to a single digit YoY in Mainland China. Sa Sa (Not rated) reported strong SSS growth (+24% YoY) in Hong Kong and Macau, but Mainland SSS declined by 3% YoY in the 1H FY12 results (six months ending September 2011) as the company ran into staffing problems at new stores.
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
MSCI China Consumer Discretionary Index MSCI China Consumer Staples Index
Source: MSCI, Bloomberg
Sector rotation from consumer discretionary into consumer staples

We have seen a recent sector rotation from discretionary stocks into consumer staples. This transition, however, has resulted in the emergence of relatively low PEG multiples for some of the consumer discretionary sub-sectors (all numbers are based on the Bloomberg consensus): Apparel retailers and brands have seen a sell-off of -13% on average over the past three months, with menswear names Trinity (-32%) and China Lilang (-27%) getting hit especially hard. However, sector average 2011E PEG (2011 PER/2012 EPS growth) is now relatively low at 0.6x. Luxury names have sold off over the past month. Prada is falling out of fashion with investors, losing 15%, Samsonite down 8%, Emperor Watches & Jewellery (Not rated) down 18% and Luk Fook (Not rated) down 19%. Meanwhile, Chow Tai Fook (Not rated), the worlds largest listed jewellery chain, has fallen 7% since its trading debut on 15 December 2011. The 2011E PEG for Emperor is 0.4x and 0.6x for Luk Fook. In contrast, over the past month, we have seen the Food & Beverage sector lose 6% and the Household & Personal Care sub-sector lose 2%. The 2011E PEG for the Food & Beverage sector is 1.2x and 1.0x for Household & Personal Care. This would support the argument that consumer discretionary stocks are relatively oversold versus the consumer staples.
Emperor is reporting no slowdown in Hong Kong. SSS growth in 3Q11 remains at 30% YoY (public guidance) although management acknowledges that Mainland growth is likely to slow in 2012 from a high base. We note that SSS growth for Emperor in 2009 was 15% YoY. Overall, we note that we are still seeing a robust trend in Hong Kong, which is due to the continuing influx of Mainland tourists. Hong Kong retail is benefitting from a pricing advantage of 30% vs. the Mainland due to the absence of import duty and luxury taxes. Moreover, shoppers have a high degree of surety of the authenticity of goods in Hong Kong and there is more retail choice. As Mainland travel restrictions are relaxed, there still seems to be a healthy pool of potential visitors to Hong Kong, in our view. This would support the argument that its better to be positioned in retailers with a Hong Kong bias.

Fear of fading wealth
Consumer discretionary retail sales have shown a buoyant trend in 2011. This is especially true of the Hong Kong luxury sector, where YoY retail sales growth for watches and jewellery reached over 50% in mid-2011.
HK YoY retail sales watch & jewellery segment
70% 60% 50% 40% 30% 20% 10% 0% (10%) (20%) Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11
Source: Bloomberg
Retail trends: slowing SSS growth in the Mainland. Hong Kong holding up well
Mainland retail sales growth will naturally slow as the economy cools. We are already seeing declining trends in the Mainland across the board:
- 41 -

3 January 2012
As Chinas economy cools, retail growth would inevitably slow, plus we have the high base effect from 2011. There is a fear that if consumers have to tighten their purse strings, they will cut back on discretionary spending.
China Yurun (Not rated) trades on PER of 7x 2012E, vs. 29x for Tingyi and 26x for Want Want (Bloomberg consensus). Vinda (Not rated) trades on PERs of 22x 2011E and 14x 2012E, vs. 32x and 25x for Hengan, respectively (Bloomberg consensus). In the short-term, investor sentiment still seems negative. However, we believe the fundamental drivers of the Mainland domestic consumption story are intact. Many consumer discretionary stocks are trading at trough valuations, and investors with a long-term perspective may look to buy on weakness. For such investors, we would recommend screening the sector for stocks that have sold off in the consumer discretionary space or mispriced stocks in consumer staples.
Determined to boost domestic spending

The Organisation for Economic Co-operation and Development (OECD) forecasts that Chinas economy will grow by the lowest rate in 11 years in 2012. However, we still forecast 8.3% YoY GDP growth in 2012 and there are several drivers for the China consumer sector that are related to the 12th FYP. In the 2011-15 plan, approved in March 2011, consumer spending should be supported by policies adopted to reach the following targets: Disposable income for urban residents to increase by a minimum of 7% per annum (50% of this increase should benefit discretionary spending). Net income for urban residents to rise by a minimum of 7% p.a. (we think as much as 70% of this rise should benefit discretionary spending). Increase urbanisation from 47.5% to 51.5%. Create 45m new urban jobs. Build 36m affordable urban housing units. Urban pension target: cover 360m people. Health insurance target: cover 70% of all medical bills. The development of social safety nets should play a role in helping to cut the savings ratio and boosting consumption.
Key call: Li & Fung (494 HK, Buy (1), HK$14.26)

Investors are right to be concerned about Li & Fungs exposure to anaemic Western economies. However, we think management is in control of earnings growth, to a large extent, as the company rationalises its cost base and a new Asian earnings driver materialises in 2012E. Indeed, in the current climate, we would favour stocks where EPS growth can be driven by internal company developments, rather than depending on external economic growth. The groups current three-year plan aims to achieve global connectivity. Li & Fungs new division, LF Asia, is building a network to distribute global brands in Asia. This development should add a new leg of earnings growth we forecast EBIT of US$198m for LF Asia (14% of group EBIT) by 2013E. We expect the Bloomberg consensus to revise up its earnings forecasts over the coming months as: Management should deliver on its target to hit an operating profit split of roughly 30% 1H11/70% 2H11. Continued top-line momentum, combined with cost control, should generate operational leverage. We forecast an EBIT margin recovery, from 3.6% for 1H11 to 4.9% for 2012. The Wal-Mart sourcing business and LF Asia should begin to contribute to earnings in 2012E. We believe the market is not yet talking about LF Asia, and that this will become a catalyst when 2011 results are released in March, along with 2011E EPS of US$8.0 cents, which is 11% higher than market consensus.
Consumer staples: the market expects margin recovery in 2012

The market is expecting a margin recovery in consumer staples, assuming revenue growth and increasing operating leverage as commodity prices soften in 2012: Tingyi (Not rated) YoY EPS growth of 33% on topline growth of 24% YoY (Bloomberg consensus). Want Want (Not rated) YoY EPS growth of 31% on top-line growth of 24.5% YoY. Tsingtao (Not rated) YoY EPS growth of 21% on topline growth of 14% YoY. Hengan (Not rated) YoY EPS growth of 30% on topline growth of 26% YoY. However, some stocks are trading at relatively low valuations versus the sector average:
- 42 -

3 January 2012
CV sales (2008-09)
('000 units) 600 500 400 300 200 100 0 (100) (YoY) 120% 80% 40% 0% (40%) (80%)
Expressways Neutral
Kelvin Lau (852) 2848 4467 (kelvin.lau@hk.daiwacm.com)
Jul-08
May-08
May-09
Jan-08
Mar-08
Jan-09
Nov-08
Mar-09
Jul-09

Sharp decline in economic environment
Chinas GDP growth slowed from 14.2% YoY for 2007 to 9.6% YoY for 2008. Economic activity contracted significantly. Passenger-vehicle (PV) sales fell on a year-on-year basis every month from August 2008January 2009 and rebounded to positive YoY growth from February 2009 on the back of supportive measures by the government. Exports and imports started to drop year-on-year in November 2008 and declined by 16% YoY and 11% YoY, respectively, for 2009. Commercial-vehicle (CV) sales began to decline YoY in July 2008 and remained weak until July 2009.
PV sales (2008-09)
('000 units) 1,400 1,200 1,000 800 600 400 200 0
Sep-08 Nov-08 Sep-09 May-08 May-09 Nov-09 Jul-08 Jan-08 Mar-08 Jan-09 Mar-09 Jul-09
CV
Source: CEIC
YoY change
China: export and import growth (2008-09)

(YoY) 80% 60% 40% 20% 0% (20%) (40%) (60%)
Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09
Exports
Source: Bloomberg
Imports
(YoY) 120% 80% 40% 0% (40%)
As a result of the deteriorating macroeconomic environment, average daily traffic and average daily toll revenue for the expressway companies declined YoY for most months in 2008-09. However, the net profits of most of the expressway companies did not fall significantly in those two years.
Expressway companies: average daily traffic growth
(YoY) 60% 30% 0% (30%)
Jul-08 May-08 May-09 Jan-08 Mar-08 Jan-09 Nov-08 Mar-09 Jul-09 Nov-09 Sep-08 Sep-09
PV
Source: CEIC
YoY change
JSE AHE
Source: Companies
ZJE SCE
HHI YTI
Nov-09
SZE
Sep-08
- 43 -
Sep-09

3 January 2012
Expressway companies: average daily revenue growth

(YoY) 50% 30% 10% (10%) (30%)
Jul-08 May-08 May-09 Jan-08 Mar-08 Jan-09 Nov-08 Mar-09 Jul-09 Nov-09 Sep-08 Sep-09
Expressway companies: net-profit changes and net-profit margins

9M08 14 (23) 106 (8) 1 n.a. 32 9M09 20 (13) (59) 7 7 33 (53) Net profit (YoY %) 9M10 27 7 (13) 25 3 41 53 9M11 1 3 (3) 23 78 2 7 2011E (0) 1 3 (38) 15 11 7
JSE ZJE HHI* SZE AHE SCE YTI*
ZJE AHE
Source: Companies
HHI SCE
SZE YTI
Expressway companies: net-profit growth (2008-09)

YoY (%) JSE ZJE HHI SZE AHE SCE YTI
Source: Companies
2008 (3) (22) 49 (14) 23 19 13
2009 29 (5) (47) 10 (0) 40 (29)
JSE ZJE HHI* SZE AHE SCE YTI*
9M08 52 29 109 55 39 38 67
Net-profit margin (%) 9M09 9M10 59 63 28 28 39 35 50 29 41 36 43 48 36 42
9M11 57 27 29 33 59 41 38
2011E 36 28 26 16 31 38 41
Source: Companies, Daiwa forecasts Note: *1H results for HHI and YTI

Greater transparency from toll-road inspections
Since June 2011, the PRC Government has been undertaking toll-road inspections, with the aim of eliminating excessive charges and illegal behaviour in the industry, which in turn could reduce the financial burden on the logistics industry. This has led to concerns in the market about the possibility of a nationwide cut in toll rates being introduced. However, in 2012, when the inspection of toll roads is due to end, we expect there to be increased transparency on whether or not toll-rate hikes will be implemented. In our view, the chances of toll rates being reduced are minimal, as the inspections and subsequent actions have focused on illegal and excessive charges. Most of the listed companies follow the toll-charge standards in their home provinces. Therefore, we expect investors to have a more positive view on the sector in 2012.
Timetable for toll-road inspections
1st stage 2nd stage 3rd stage 4th stage Period 20 Jun 11-31 Aug 11 01 Sep 11-31 Dec 11 01 Jan 12-29 Feb 12 01 Mar 12-31 May 12 Remarks Data collection by the provincial government Rectification carried out by each provincial government Review of inspections by central government Conclusion of the inspections by the provincial and central governments
Where are we now?

Growth weakening but not yet negative
According to recent data, the traffic and revenue growth of the expressway companies has weakened to single-digit percentages year-on-year since 3Q11. Unlike the period of 2008-09, however, most of the expressway companies managed to achieve positive year-on-year rises in both traffic and revenue through 9M11. Unlike in 2008 and 2009, the net profits for JanuarySeptember 2011 did not decline significantly YoY for most of the companies. Improvements in net-profit margins varied by expressway company over the same period.
Source: NDRC, Ministry of Transport, Ministry of Finance, various media
- 44 -

3 January 2012
Macro environment not as bad as in 2008

Daiwas economic for Greater China, Mingchun Sun, forecasts Mainland GDP growth to slow from 9.2% YoY for 2011 to 8.3% YoY for 2012, and exports and imports growth rates of 19.5% YoY and 24.7% YoY for 2011, and 7% YoY and 9.2% YoY for 2012. However, we do not expect a sharp decline in GDP growth or YoY declines in exports or imports, as we do not see the likelihood of massive destocking in 2012 due to low inventory levels since 2010. In addition, Daiwas China auto analyst, Jeff Chung, forecasts a 9% YoY increase in PV sales for 2012, better than his forecast for a 7% YoY increase for 2011.
US inventory to sales ratio vs. global RFTK growth
(%) 1.20 1.18 1.16 1.14 1.12 1.10 (%) 35 25 15 5 (5)
Thematic pick: Yuexiu Transport Infrastructure

Yuexiu Transport Infrastructure (YTI) is our top pick in the sector, due to several company-specific catalysts that we see, and its focus on inland provinces. Compared with the other expressway companies, YTI is more aggressive in searching for new projects outside its own province of Guangdong. Management plans to focus its expansion efforts on the inland provinces as it sees better traffic growth there than in the coastal provinces, as a result of inland provinces higher GDP growth. The companys recent acquisitions of the Hanxiao, Changzhu and Weixu expressways were at internal rates of return of 12-15%, higher than the projects announced recently by other expressway companies.

Based on our 2012 forecasts, the stock is currently trading at a PER and EV/EBITDA multiple of 6.5x, below its past-five-year average PER of 10x and EV/EBITDA of around 8x. We forecast dividend yields of 8% and 9% for 2011 and 2012, respectively, which should limit share-price downside, in our view. We see the major share-price catalysts as the potential introduction of a toll-by-weight system in Guangdong, continued asset acquisitions in inland provinces, and more trucks using the companys major toll road, the Guangzhou North Second Ringroad.
YTI: 12-month-forward PER and EV/EBITDA
YTI 2005 2006 2007 2008 2009 2010 Current 2011E Current 2012E Past-five-year average Past-10-year average PER (x) 6.9 8.4 15.6 8.9 9.2 9.4 8.0 6.5 10.3 9.7 EV/EBITDA (x) 7.5 6.8 10.5 8.8 7.9 7.8 6.3 6.5 8.3 8.2
Source: Bloomberg, IATA
Coastal expressways would be under higher pressure

We expect the mature coastal expressway companies to face greater pressure on their profitability due to weakening exports and imports than those expressway companies focused on the inland regions. Given the trend for inland migration and continued development of the countrys central and western provinces, we expect higher GDP growth in these regions than those on the coast. As a result, traffic and revenue growth in the inland provinces should be better than in the coastal provinces.
Truck contribution to traffic and revenue (2010)
Company Truck traffic (% of total traffic) Truck revenue (% of total revs)
Source: Companies
Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11
US inventory-to-sale ratio (LHS) Global RFTK YoY % (RHS)
JSE 35 55
ZJE 30 65
HHI 7 20
SZE 20 40
AHE 40 60
YTI 33 45
SCE 35 55
Source: Bloomberg, Thomson Reuters, Daiwa forecasts
- 45 -

3 January 2012
Expressways: target prices

Company Yuexiu Transport Infrastructure Anhui Expressway Co. Ltd. Jiangsu Express Co. Ltd. Shenzhen Expressway Co.
Bloomberg code 1052 HK 995 HK 177 HK 548 HK
Share price 19-Dec-11 (local curr.) 3.31 4.08 6.85 3.34
Six-month Upside/downside target price potential (%) (local curr.) 6.00 81.3 6.50 59.3 7.60 10.9 3.30 (1.2)
2012E PER (x) 6.5 5.7 10.9 8.2
Valuation basis DCF-based DCF-based DCF-based DCF-based
Expressways: valuation summary

PER EV/EBITDA Dividend yield Share price Six-month (x) (x) (%) target price +/- Year end 19-Dec-11 Company Bloomberg code (local curr.) Rating (local curr.) (%) 2010 2011E 2012E 2013E 2010 2011E 2012E 2013E 2010 2011E 2012E 2013E Yuexiu Transport Infrastructure 1052 HK 3.31 Buy 6.00 81.3 Dec 8.6 8.0 6.5 5.0 4.9 6.3 6.5 4.9 6.8 7.5 9.2 12.1 Anhui Expressway Co. Ltd. 995 HK 4.08 Buy 6.50 59.3 Dec 7.1 6.2 5.7 5.0 4.2 4.2 3.8 3.2 6.2 7.2 7.9 9.1 Jiangsu Express Co. Ltd. 177 HK 6.85 Outperform 7.60 10.9 Dec 10.9 11.2 10.9 10.2 7.4 7.0 6.5 5.9 6.4 6.2 6.4 6.9 Shenzhen Expressway Co. 548 HK 3.34 Hold 3.30 (1.2) Dec 6.6 10.6 8.2 7.6 8.5 6.5 6.5 5.3 5.8 6.4 5.8 6.3
- 46 -

3 January 2012
Where are we now?
Gaming and Leisure Positive

Gavin Ho, CFA (852) 2532 4384 (gavin.ho@hk.daiwacm.com)
We believe there are a few differences in the industry and market dynamics that provide a favourable outlook for the sector and its valuation multiple compared with the previous financial crisis: Share-price movements also factored in the markets concerns about the restrictive visa policies affecting the industry at that time. The market cap and liquidity of the Macau gaming stocks in 2008 were very small percentages of what they are currently, prompting many investors to simply dismiss the sector, similar to the way they regard small-cap stocks in difficult market times. The two largest stocks by market cap Sands China and Wynn Macau were only listed in 4Q09, while SJM was only listed in the middle of 2008. A number of Macau stocks, such as Galaxy and Melco Crown, were trading on expectations of contributions from new properties under construction Galaxy Macau and City of Dreams for which the market applied massive discounts in 2008.

Revenue fall in 2008 was abrupt and event-driven
Although concerns about a slowdown in gamingrevenue momentum were raised in the early months of 2008 and visa restrictions (for Mainland visitors) started to apply from the middle of the year, gaming revenue started to fall only in September, recording a 1% YoY fall for that month, after seeing YoY growth in excess of 30% for the 24 months before that.
Macau: gaming revenue (YoY change %)
100% 80% 60% 40% 20% 0% (20%) (40%)

A deceleration, not a sharp fall
Our China economics team does not expect a sharp fall in Chinas economic growth in 2012 followed by a Vshaped rebound. Rather, it believes the countrys GDP growth will continue to consolidate further from the 8.5% YoY increase it forecasts for 2012.
Jul-06
Jul-07
Jul-08
Jul-09
Jul-10
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jul-11
China: GDP growth

YoY (%) 17 15
Source: DICJ
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011E
- 47 -
2012E
We believe the sudden fall in September was triggered by the Lehman crisis and defaults in derivativeinvestment products that resulted in a sharp fall in wealth, or even financial distress, for companies and individuals. Also, we believe the credit cycle for VIP gaming became longer, leading to a lower rolling multiple and hence lower VIP gaming revenue.
13 11 9 7 5

3 January 2012
Under this economic scenario, we believe the Macau gaming industry will also react differently this time (from 2008). Rather than a sharp gaming revenue fall triggered by a major catastrophic financial event, the deceleration in Chinas GDP growth should occur in a moderate and more orderly manner in 2012. As a result, we forecast 2012 Macau gaming-revenue growth to moderate to 20% YoY (from 58% YoY for 2010 and 44% YoY for January-November 2011).
Shift of momentum to Cotai

The opening of Galaxy Macau has accelerated the shift of gaming-revenue momentum to Cotai, which we estimate accounted for 26% of Macaus gaming revenue for 3Q11 (from 22% in 1Q11), and we expect the trend to continue with the opening of Sands Cotai Central, scheduled for early 2012. This, together with the other Cotai properties, should provide a greater cluster effect. In addition, the higher mass-market (than VIP) revenue growth we expect should favour those properties that are more mass-market-focused in Cotai and their operators: Galaxy, Melco Crown, and Sands China.
Macau: Cotais share of gaming revenue
(MOPm) 120,000 100,000 80,000 60,000 40,000 20,000 0 2007 2008 2009 2010 2011E 2012E Cotai gaming revenue (LHS)
Faster growth in mass market (than VIP)

For 2012, we forecast mass-market gaming revenue to rise by 25% YoY, on the back of the following. A 12% YoY rise in Mainland visitor arrivals, compared with a 15% YoY average since 2006. A 12% YoY increase in average gaming spend, on the back of the 12% per-capita GDP growth Daiwas economics team forecasts for China. We note that in 2009, although there was a 5% YoY decline in Mainland visitor arrivals, mass-market gaming revenue managed to rise by 13% YoY. Meanwhile, we forecast 2012 VIP gaming revenue to grow by 18% YoY, on the back of the following. Stable junket capital from the end of 2011 to the end of 2012. We forecast MOP19.5bn in VIP gaming revenue for December 2011, and calculate that there is MOP91bn in liquidity in the system, based on a 2.85% win-rate and a 7.5x rolling multiple. We believe a stable capital level is a very conservative assumption, given the strong balance sheets of the casinos and the junkets: in addition, there will be a major property opening in 2012. A gradual lowering of the rolling multiple from 7.5x at the beginning of 2012 to 6.5x by the end of 2012. Overall, our gaming-revenue growth forecast for Macau is 20% YoY for 2012.
Macau: VIP and mass-market gaming-revenue growth
80% 70% 60% 50% 40% 30% 20% 10% 0% 2006 2007 2008 VIP
35% 30% 25% 20% 15% 10% 5% 0% Mix in Macau (RHS)
Thematic pick: Galaxy

We believe Galaxy Macau has proven itself as a competitive property in Cotai, pushing up Galaxys market share from 11% in 1Q11 to 19% in 3Q11. While we believe the market could be factoring in slower gamingrevenue growth for 2012, Galaxy should continue to see strong growth with Galaxy Macau. We believe Galaxy is a key beneficiary of the structural trend in the shift of gaming revenue to Cotai, and forecast the company to see a high EBITDA CAGR of 30% for 2011-13, compared with a sector average of 17%.
2009
2010
9M11
2011E
2012E
Mass market
- 48 -

3 January 2012
Galaxy: EBITDA breakdown (HK$m)

10,000 8,000 6,000 4,000 2,000 0 (2,000) 2011E StarWorld Construction materials
Thematic pick: Sands China

We believe Sands China offers a distinctive combination of gaming-revenue growth and resilience within the Macau gaming sector. With the opening of Sands Cotai Central in 2012, we expect Sands China to increase its market share (from 14% in 3Q11 and 16% for 2011) to 18% for 2012, and forecast the operator to post a high EBITDA CAGR of 29% for 2011-13 (compared with an industry average of 17%). The company is also the most exposed to the mass-market segment (40% compared with the industry average of 27% for 1H11), which we believe is more resilient in a downturn and, in addition, offers stronger long-term gaming-revenue growth potential.
Macau: mass-market (as a % of gaming revenue) (1H11)
45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Sands China
Source: Company
2012E Galaxy Macau Corporate expenses
2013E City Clubs

Galaxy is trading currently at 2011E and 2012E EV/EBITDA multiples of 12x and 8x, respectively, compared with the sector averages of 11x (2011E) and 8x (2012E). However, we forecast the company to see 2011 and 2012 EBITDA growth of 147% YoY and 43% YoY, respectively, compared with industry averages of 66% (2011E) YoY and 19% YoY (2012E). Our six-month target price of HK$19.54 is based on a target EV/EBITDA multiple of 11x on our 2012 EBITDA forecast, at a 10% premium to our 10x target for the sector, in light of the strong revenue momentum at Galaxy Macau.
Galaxy: EV/EBITDA (x)
20
SJM
Wynn Macau MGM China
MPEL
Galaxy

Sands China is trading currently at 2011E and 2012E EV/EBITDA multiples of 15x and 11x, respectively, which compare with averages of 11x for 2011E and 8x for 2012E for the sector, based on our forecasts. We forecast the company to deliver 2011 and 2012 EBITDA growth of 35% YoY and 34% YoY, respectively.
May-10 Sep-10 2011E EV/EBITDA Jan-11 May-11 2012E EV/EBITDA Sep-11
16
12
4 Jan-10
Our six-month target price of HK$26.25 is based on a target EV/EBITDA multiple of 12x on our 2013 EBITDA forecast and discounted by one year (to allow for a full-year contribution from Sands Cotai Central).
We believe Galaxy Macau demonstrates Galaxys ability to develop and operate mega projects, and a second phase would be welcomed by investors, in our view. While we do not expect Galaxy Macaus casino to see any capacity issues over the near to medium term, other non-gaming developments, such as hotel rooms, entertainment facilities, and retail, could be developed to strengthen its positioning, especially in the massmarket segment.
- 49 -

3 January 2012
Sands: EV/EBITDA (x)

20
16
12
The next mega-project opening planned for Cotai, Sands Cotai Central, should not only help the operator gain market share and drive strong revenue and EBITDA growth, it should also attract considerable investor attention given its significance for the sector. In our view, Sands Chinas share price will also respond the most positively to any strengthening in Macau gaming-revenue momentum given this new opening.
4 Jan-10
May-10
Sep-10 2011E EV/EBITDA
Jan-11
May-11 2012E EV/EBITDA
Sep-11
Source: DICJ, Daiwa forecasts
Gaming and Leisure: target prices

Company Galaxy SJM Holdings Sands China Melco Crown Melco International MGM China Shun Tak Wynn Macau
Bloomberg code 27 HK 880 HK 1928 HK MPEL US 200 HK 2282 HK 242 HK 1128 HK
Share price Six-month Upside/downside 19-Dec-11 target price potential 2012E PER (local curr.) (local curr.) (%) (x) Valuation basis 13.90 19.54 40.6 10.5 11x 2012E EV/EBITDA multiple 12.82 16.44 28.2 10.2 9x 2012E EV/EBITDA multiple 20.75 26.25 26.5 16.7 12x 2013E EV/EBITDA multiple and discounted by one year 8.81 11.27 28.0 15.4 9x 2012E EV/EBITDA multiple 5.66 6.67 17.8 11.9 40% discount to 2012E NAV 10.16 11.80 16.1 9.6 8x 2012E EV/EBITDA multiple 3.03 3.52 16.2 4.1 70% discount to 2012E NAV 18.22 20.33 11.6 13.9 12x 2012E EV/EBITDA multiple
Gaming and Leisure: valuation summary

Company Galaxy SJM Holdings Sands China Melco Crown Melco International MGM China Shun Tak Wynn Macau Bloomberg code 27 HK 880 HK 1928 HK MPEL US 200 HK 2282 HK 242 HK 1128 HK Share price 19-Dec-11 (local curr.) Rating 13.90 Buy 12.82 Buy 20.75 Buy 8.81 Outperform 5.66 Outperform 10.16 Outperform 3.03 Hold 18.22 Hold Six-month target price (local curr.) 19.54 16.44 26.25 11.27 6.67 11.80 3.52 20.33 +/- Year (%) end 40.6 Dec 28.2 Dec 26.5 Dec 28.0 Dec 17.8 Dec 16.1 Dec 16.2 Dec 11.6 Dec 2010 53.2 18.5 32.2 n.a. n.a. 25.2 15.8 21.4 PER (x) 2011E 2012E 2013E 19.9 10.5 8.2 12.2 10.2 8.8 23.4 16.7 12.6 27.7 15.4 11.1 24.0 11.9 8.2 10.1 9.6 8.5 8.1 4.1 5.4 16.7 13.9 12.4 2010 27.5 12.3 20.2 14.3 n.a. 15.2 27.4 16.5 EV/EBITDA (x) 2011E 2012E 2013E 11.8 7.5 5.4 8.0 6.5 5.3 14.9 11.4 8.7 9.5 7.8 6.4 n.a. n.a. n.a. 8.0 6.7 5.2 10.8 5.9 2.5 11.7 10.6 9.1 2010 0.0 2.7 0.0 0.0 0.0 0.0 2.0 4.2 Dividend yield (%) 2011E 2012E 2013E 0.0 0.0 0.0 4.1 4.9 5.7 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 3.7 7.3 5.5 2.1 2.5 2.8
- 50 -

3 January 2012
China: machinery shipments (% YoY change)

2006 2007 2008 2009 2010 10M11
Source: CMMA
Heavy Machinery Negative

Joseph Ho, CFA (852) 2848 4443 (joseph.ho@hk.daiwacm.com) Winston Cao (852) 2848 4469 (winston.cao@hk.daiwacm.com)
Excavators 47 44 16 22 77 17
Wheel-loaders 21 25 0 (8) 53 15
Road rollers 28 73 11 (16) 26 (8)
Bulldozers 16 22 21 (1) 62 (1)
Lonking was the only choice at that time

In 2008, the top three China players Sany Heavy Industry (Sany) (Not rated), Zoomlion, and XCMG (Not rated) were listed only in the A-share market. As such, foreign investors had a limited choice when it came to gaining exposure to the countrys construction machinery sector. Lonking, the No.1 wheel-loader maker in the country, was the only China construction machinery maker listed in Hong Kong at that time. Its share price rebounded sharply in 2009 and reached a record high in early 2011.
Lonking: PER bands
(HK$) 7 6 5 4 3 2 1 0 Jan/07
60%

Rmb4tn fixed-asset investment-led stimulus
A review of the China construction-machinery market during the 11th Five-Year Plan (2006-10) period shows that the markets sales expanded by over 30% YoY annually, with the exception of 2008 and 2009 when growth slowed to 25% YoY and 14% YoY, respectively, amid the financial crisis. In 2010, industry sales rebounded sharply by 33% YoY to a new high of Rmb420bn, underpinned by the Rmb4tn FAI-led stimulus programme initiated in late 2008.
China: construction machinery sales
1,000 37%
Jul/07
Jan/08 10x
Jul/08
Jan/09 15x
Jul/09
Jan/10
Jul/10
Jan/11
Jul/11 5x
Share Price
Sales (Rmb bn)
800 600 400 200 0
28%
33% 25% 14% 420 316
40% 20% 0% (20%) (40%)
Source: Bloomberg
Where are we now?

One more choice for overseas investors
In December 2010, Zoomlion (the No.2 construction machinery maker in China) completed its H-share listing to become the second China construction machinery maker listed in Hong Kong, raising US$1.9bn in funds (1bn shares at HK$14.98 each), which helped strengthen its balance sheet (note: the companys pre-IPO net gearing was over 140%) and fund its business growth. In September 2011, a weak market response forced Sany and XCMG to cancel their planned H-share listings. Lonking and Zoomlion are currently the only two choices for overseas investors seeking exposure to the China construction machinery sector.
162
222
277
2006
Source: CMMA
2007 Total sales (LHS)
2008
2009 YoY change (RHS)
2010
The following table shows the year-on-year change in the unit shipments of various categories of construction machinery during the 11th Five-Year Plan period. Shipments of wheel-loaders, road rollers, and bulldozers contracted in 2009.
- 51 -

3 January 2012
Decelerating earnings/revenue growth in 2011

Although they enjoyed strong sales and earnings growth for 1Q11, the China heavy-machinery makers have found the remainder of 2011 a rough ride, as the industry saw a sharp deceleration in business growth amid slowing FAI in China in various infrastructure projects (eg, high-speed railways, wind-farm buildouts), government policies to cool the private housing market, and credit tightening by the PBOC (interest rate and RRR hikes). The following table shows the decelerating sales momentum of the top-three China heavy-machinery makers in 2011.
Top players: quarterly sales
Sales (Rmb bn) Sany Zoomlion XCMG YoY chg (%) Sany Zoomlion XCMG
Source: Companies
Zoomlion: quarterly earnings 2011 vs. 2010

3.0 2.5 2.0 1.5 1.0 0.5 0.0 1Q 2Q 2011
Source: Company, Daiwa (4Q11 earnings forecast)
2.6 2.0 1.3 1.5 0.9 1.5 1.5
Net profit (Rmb bn)
0.7
3Q 2010
4Q
1Q11 14.0 10.7 9.7
2Q11 16.4 13.4 9.8
3Q11 10.9 9.1 5.7
9M11 41.3 33.2 25.2
Higher accounts-receivable risks

Compared with 2008, in addition to slowing demand for new machinery, the key industry players are also facing higher accounts-receivable risks (currently) as credit sales under finance leases have expanded rapidly and have been funded by their balance sheets. As an example, we estimate that Zoomlions finance-lease sales will account for about 30% of total sales in 2011, up from 4% in 2007.
92 82 75
68 32 28
22 16 (3)
59 39 30
The following chart shows the negative impact of the macroeconomic-tightening policy on investment. Shipments of excavators started to decline on a yearon-year basis from May 2011. In November, industry excavator shipments fell by 38% YoY.
China: monthly excavator shipments
(Units) 50,000 40,000 30,000 20,000 10,000 0

FAI-led stimulus unlikely to happen
Chinas first RRR cut in three years is a positive macroeconomic move, in our view, but it will take time to filter down to the machinery makers, which are at the bottom of the food chain. Also, we think it is unlikely that China will decide on another Rmb4tn FAI stimulus package. As a result, we expect the 2H11 industry weakness to continue into 1Q12, and for shipments of key machinery categories, including excavators and truck cranes, to remain weak in 1H12. For Zoomlion, we forecast year-on-year declines in 1Q12 and 2Q12 earnings, and for earnings to pick up only in 3Q12 at the earliest (see the following chart).
Zoomlion: quarterly earnings 2012E vs. 2011
3.0 2.5 2.0 2.1 1.5 1.0 0.5 0.0 1Q 2Q 2012E
Source: Company, Daiwa (4Q11 earnings forecast)
Feb
Apr
Aug
Sep
Jan
Jun
Oct
Nov
2011
Source: CMBOL, Daiwa
May
2010
2009
Dec
Mar
Jul
2.6
Net profit (Rmb bn)
At the company level, the slowdown in Zoomlions earnings momentum started from 2Q11. For 4Q11, we forecast Zoomlion to report zero earnings growth on a year-on-year basis.
2.0 1.5
1.7
1.9
1.3
1.5
3Q 2011
4Q
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3 January 2012
In our view, companies with weaker balance sheets will be more vulnerable to a slump in end-market demand and a tight credit environment. The pecking order as at 30 June 2011 in terms of net gearing is Lonking (40%), Sany (30%), Zoomlion (net cash), and XCMG (net cash).

We have a Hold (3) rating and DCF-based six-month target price of HK$8.50 for Zoomlion, which translates into an implied 7.5x PER target on our 2012 EPS forecast of Rmb0.93 (Bloomberg consensus: Rmb1.08). A rapid easing of the macroeconomic-tightening policy would be a share-price catalyst, in our view, while a deterioration in accounts receivable would be a downside risk to our target price and rating.
Valuation: 2012E PER peer comparison
(x) 15 10.6 10 5 0
Zoomlion (H) Caterpillar Komatsu Lonking Doosan XCMG Sany
Thematic pick: Zoomlion

We have a Negative rating for the sector. We believe investors should consider bargain hunting from 2Q12 rather than at the beginning of 2012. At the stock level, Zoomlion has the highest rating among the companies we cover in the sector. We like the companys prudent stance (in terms of expanding credit sales) amid the industry downturn and because it puts risk control ahead of achieving top-line growth. This is in stark contrast to Sanys aggressive expansion strategy. Separately, we think Zoomlion has a less volatile business profile, given a more balanced 2012 sales mix between cranes and concrete machinery than XCMG and Sany.
Top three players: sales mix by product
100% 80% 60% 40% 20% 0% Sany Concrete machinery Zoomlion Excavators Crane machinery 52% 14% 10% 23% 34% 2% 51% 46% 6% XCMG Others 17% 43%
(x) 15 9.9 8.8 8.1 7.4 10 5.1 5 0
6.1
2012E PER
Average 8.0x
Source: Daiwa forecasts for Zoomlion and Lonking, Bloomberg
Valuation: 2012E PBR versus ROE peer comparison

2012E PBR (x) 6.0 5.0 4.0 3.0 2.0 1.0 0.0 0.0 Terex Hitachi 10.0 Komatsu Sandvik Doosan Atlas Caterpillar Sany
Zoomlion 20.0
XCMG Lonking 30.0 40.0 50.0
Source: Companies, Daiwa (4Q11 earnings forecasts)
2012E ROE (%)

Source: Daiwa forecasts for Zoomlion and Lonking, Bloomberg
Heavy Machinery: target prices

Company Zoomlion Lonking
Bloomberg code 1157 HK 3339 HK
Share price Six-month Upside/downside 19-Dec-11 target price potential 2012E PER (local curr.) (local curr.) (%) (x) Valuation basis 4.9 7.1 DCF 8.1 8.5 2.58 2.51 (2.7) 4.9 DCF
Heavy Machinery: valuation summary

Company Bloomberg Code Zoomlion 1157 HK Lonking 3339 HK Share price Six-month 19-Dec-11 target price (local curr.) Rating (local curr.) 8.1 Hold 8.5 2.58 Underperform 2.51 +/(%) 4.9 (2.7) Year end Dec Dec PER (x) 2012E 7.1 4.9 EV/EBITDA (x) 2011E 2012E 2013E 2010 4.8 4.6 3.8 3.7 4.2 4.1 3.8 6.5 Dividend yield (%) 2011E 2012E 2013E 5.1 4.9 5.7 5.9 6.2 6.6
2010 8.9 4.9
2011E 6.8 5.2
2013E 6.2 4.7
2010 6.2 4.6
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3 January 2012
Growth: GDP vs. transport-infrastructure FAI

(%) 80 70 60 50 40 30 20 10 0 (10) (20)
1Q05 3Q05 1Q06 3Q06
Fiscal stimulus to boost economic growth
(% YoY change) 16 14 12 10 8 6 4 2 0
Infrastructure Neutral
Edwin Lee (852) 2532 4349 (edwin.lee@hk.daiwacm.com)
1Q07
3Q07
1Q08
3Q08
1Q09
3Q09
1Q10
3Q10
1Q11

Counter-cyclical amid slowing economic growth
Infrastructure investment was counter-cyclical during the economic slowdown in 2008, due mainly to the governments stimulus measures. At that time, the PRC Government unveiled a Rmb4tn stimulus package to boost the economy, in which 37.5% was allocated to transport infrastructure, and railway construction in particular.
China: Rmb4tn stimulus package
Category Transportation-infrastructure and power-grid construction Rebuilding due to Sichuan earthquake Improving rural livelihoods and infrastructure Environmental protection Social security and housing Technological innovation Public healthcare and education Total budget
Source: NDRC
Transport infrastructure (LHS)

Source: Bloomberg, CEIC
GDP (RHS)
FAI growth: transport infrastructure

(YoY) 100% 80% 60% 40% 20% 0% (20%) Boom in high-speed train investment from 2008-09
Rmb bn % of total 1,500 37.5 1,000 25 370 9.3 210 5.3 400 10 370 9.3 150 3.8 4,000 100
(40%) 2005 2006 2007 Railways 2008 2009 Highways 2010 2011E 2012E 2013E Waterways
Source: Ministry of Railways, Ministry of Transport, Daiwa forecasts
Where are we now?

A turning point in investment growth
Strong investment came with the threat of inflation. We note that the profitability of the infrastructureconstruction companies deteriorated while revenue growth was strong over 4Q08-2Q09. The weak profitability from 2009-10 was partly due to an accounting issue (whereby the first 20% of revenue can only be booked at cost, which means a zero gross-profit margin). However, large-scale investment and accelerating construction speed also drove up labour costs and material costs significantly from 2009-10. To make matters worse, the massive construction starts lowered the efficiency of the construction companies as a result of sharply expanding market volume with limited resources (engineers and equipment).
Unlike GDP growth, which slowed from 4Q08-2Q09, transport-infrastructure FAI recorded significant growth, on the back of a great leap forward in railway construction. In order to boost economic growth, the government adopted an aggressive construction plan for high-speed trains, which was proposed by the former head of the Ministry of Railways (MOR), Liu Zhijun. Moreover, with sufficient liquidity (lower interest rates and RRR), local governments also actively invested in local infrastructure projects, financed by bank loans through LGFVs.
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3Q11

3 January 2012
Revenue growth: infrastructure-construction companies (% YoY)

120 100 80 60 40 20 0 (20) (40) 1H08 2H08 1H09 2H09 1H10 2H10 China Railway Group (390 HK) China Railway Construction (1186 HK) China Commmunication Construction (1800 HK) 1H11
new projects due to a lack of working capital. Therefore, the growth of overall transport investment has slowed significantly since the peak from 2008-09.

The worst should be behind us
In late-2011, the government introduced more supportive measures for the infrastructure sector, such as government-backed bonds and tax benefits for railway bonds, and injected liquidity into the monetary system (in the form of an RRR cut). After the very tight monetary environment in 2011, we expect a relative loosening of the monetary environment in 2012, and believe the worst period for infrastructure investment is over. However, we regard the purpose of the loosening to be to avoid an economic hard-landing, rather than provide the market with abundant funding. That said, we do not expect another round of infrastructure-stimulus measures and believe spending on key transport infrastructure (railways, highways, and waterways) will not exceed the 2010 level, while less investment in railway construction should offset the stable growth in highway and waterway investment.
Growth of outstanding loans for local government debt
70%
Source: Companies
Gross-profit margin: infrastructure-construction companies (%)

11 10 9 8 7 6 5 1H07 2H07 1H08 2H08 1H09 2H09 1H10 2H10* China Railway Group (390 HK) China Railway Construction (1186 HK) China Commmunication Construction (1800 HK) 1H11 GP margin has trended down since the stimulus measures started
Source: Companies Note: *The margin of CRC adjusted for one-off item
Apart from the diminishing influence of the stimulus package, investment in railway construction has slowed since the change in the MORs leadership in early 2011. We believe the investment plan for railway construction is likely to be trimmed further due to concerns about the popularity and safety of high-speed trains. Moreover, funding shortages have been a key issue for infrastructure investment. In the past, local governments have found it easy to finance infrastructure projects, obtaining construction loans at a discount to the benchmark rate. Now, amid the worsening debt problems of these local governments, most infrastructure projects can only be financed at the benchmark rate, or even at a premium to this rate. Exacerbating the situation, investor concerns about delayed payments from customers for infrastructure projects increased in 2H11. In theory, the default risk of government-related entities should be very low and project owners should be able to settle outstanding payments sooner or later, in our view. However, we understand that large delayed payments can affect the cash flows of the construction companies, increasing their financing costs and stopping them from taking on
60% 50% 40% 30% 20% 10% 0% 1997 1998 2002 2007 2008 2009 2010 2011
Source: National Audit Office
LGFVs surged along with the stimulus
Will the cycle be repeated?
Impact on different segments will vary

We believe the ongoing safety issue will remain an overhang on railway investment. Against the backdrop of slowing infrastructure investment, railway earnings will be more vulnerable than other infrastructure, such as highways and waterways. As such, we prefer companies with less exposure to the railway-related construction business. For the railways specifically, we believe the demand for rolling stock will remain intact over the long term. New orders for rolling stock should resume in early 2012. We believe the demand for railway equipment will
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3 January 2012
probably be more sustainable than demand for construction work on the back of: 1) more new line completions during 2012-13, and 2) the frequency of trains in operation should increase over the long term. As such, we prefer the equipment companies to the construction plays within the railway segment.
railway segment. In addition, we believe its strongerthan-peers cash-flow management should limit the company from counterparty risk amid the tightened monetary environment. Therefore, we believe the stock is the best-positioned in the sector and should outperform its peers.
Thematic pick: China Communication Construction

In our view, the reason the sector traded in such a low valuation range in 2011 was mainly due to investor concerns about the declining investment amount in transport infrastructure and rising receivables risk. That said, product mix and risk management should be the keys to differentiate companies, as we expect railway revenue to be the most vulnerable and the poor financial situation of the MOR to continue in 2012. In our view, there is little risk to China Communication Constructions (CCC) business portfolio due to its limited exposure to the vulnerable
Infrastructure: target prices
Bloomberg Company code China State Construction International 3311 HK China Communications Construction 1800 HK CSR Corp. 1766 HK China Railway Construction 1186 HK China Railway Group 390 HK

The stock is currently trading at a 2012E PER of 5.4x. Our DCF-based six-month target price of HK$7.50 suggests 26.5% upside from the current share-price level. Our target multiple for CCC, a 7x 2012 PER, is in line with the current trading range of its China construction peers, and 1SD below the past-10-year average of its Asia peers. We believe such a valuation is undemanding. The major share-price catalysts would include: 1) strong new contract growth, 2) a full-year turnaround in the heavy machinery business, and 3) the successful completion of an A-share listing.
Share price Six-month Upside/downside 19-Dec-11 target price potential 2012E PER (local curr.) (local curr.) (%) (x) Valuation basis 5.13 7.20 40.4 9.3 DCF valuation 5.93 7.50 26.5 5.4 DCF valuation 5.03 5.60 11.3 12.5 DCF valuation 4.33 4.60 6.2 6.3 DCF valuation 2.61 2.70 3.5 6.8 DCF valuation
Infrastructure: valuation summary

Bloomberg Company code China State Construction International 3311 HK China Communications Construction 1800 HK CSR Corp. 1766 HK China Railway Construction 1186 HK China Railway Group 390 HK
Share price 19-Dec-11 5.13 5.93 5.03 4.33 2.61
Rating Buy Buy Hold Hold Hold
Six-month target price (local curr.) 7.20 7.50 5.60 4.60 2.70
+/(%) 40.4 26.5 11.3 6.2 3.5
Year end 2010 Dec 14.7 Dec 7.3 Dec 19.2 Dec 10.3 Dec 6.0
PER PBR ROE (x) (x) (%) 2011E 2012E 2013E 2010 2011E 2012E 2013E 2010 2011E 2012E 2013E 12.6 9.3 7.3 3.3 1.9 1.7 1.4 25.5 20.2 18.9 20.8 6.2 5.4 5.0 1.2 1.0 0.9 0.8 17.2 18.0 17.8 17.1 14.0 12.5 10.4 2.5 1.7 1.5 1.4 13.8 14.2 12.8 13.8 6.6 6.3 6.1 0.8 0.7 0.7 0.6 7.7 11.0 10.7 10.3 8.8 6.8 6.5 0.7 0.6 0.6 0.5 11.7 7.5 9.0 8.7
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3 January 2012
Investments hit from equities partly offset by bond portfolio

In 2008, interest rates were relatively high, with the PBOC one-year benchmark rate at 4.14% for most of the year. With the high interest rates and dividend income, and the appreciation of the insurers bond portfolios, insurers were able to offset part of the losses from their equity investments. Therefore, the hit on insurers embedded value from the worse-thanexpected investment returns was only about 6.4-13.3%, and the average drop in book value was only 16.2% (only Ping An Insurance [Ping An] took a bigger hit from an impairment loss on Ageas), even though the insurers EV investment return assumptions were more aggressive and insurers had greater exposure to equities and funds at that time.
Insurers: investment portfolios (2007)
(Rmb m) China Life Ping An CPIC China Taiping PICC P&C Equity & funds 195,120 128,931 65,059 12,755 16,978 Dec-07 Bonds Total investments 450,325 860,066 235,373 464,997 131,230 286,197 27,747 51,099 28,465 76,764 Equity & funds as a % of total 22.7 27.7 22.7 25.0 22.1
Insurance Positive
Jennifer Law (852) 27738745 (Jennifer.law@hk.daiwacm.com)

Life premium growth was fast but margins were low
In 2008, the China life insurers were still seeing very strong premium growth, on the back of soaring sales of investments and savings-type insurance products. Overall life-industry premium growth for 2008 was 48.3% YoY, with the big listed players seeing premium growth of 19.4-50.3% YoY. Nonetheless, value of new business (VNB) growth was much slower than headline premium growth, because a large proportion of the products sold were single premiums/short-term regular premiums, for which margins were low.
Source: Company, Daiwa Note: Figures for Taiping Life are in HK$m
P&C 2008 was the start of a turnaround

On the P&C side, premium growth was moderate in 2008. Overall P&C industry premium growth was 17.2% YoY, slightly below the 21.0% CAGR for the previous five years. Competition was fierce, as many insurers had strong solvency positions after the stockmarket rally in 2007. It was a bad year for underwriting, due to the huge claims from the snowstorms and the earthquake in China. But the poor underwriting performance, and the stock-market fall in 2008, encouraged the P&C insurers to focus more on underwriting profitability, which resulted in good years for the industry from then until now.
Insurers: premium and VNB growth (2008)
(Rmb m) China Life Ping An Life CPIC Life Taiping Life PICC P&C Ping An P&C CPIC P&C Taiping Insurance 2007 196,611 79,177 50,687 15,842 88,592 21,450 23,433 3,414 Total premiums 2008 % chg YoY 295,591 50.3 101,178 27.8 66,092 30.4 18,910 19.4 101,656 14.7 26,751 24.7 27,817 18.7 4,261 24.8 2007 12,047 7,187 3,015 603 VNB 2008 % chg YoY 13,924 15.6 8,541 18.8 3,651 21.1 865 43.4
China: interest rate and bond yield (2008)

(%) 5 4 3 2 1 0 Jan-07 Jul-07 Jan-08 PBOC 1-yr benchmark rate China 5-yr govt bond yield China 10-yr govt bond yield
Source: CEIC, Bloomberg
Jul-08
SHSZ300 CSI Index performance (2008)

7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Jul-07
Source: CIRC, Companies, Daiwa Note: VNB figures for Taiping Life are in HK$m
Oct-07
Jan-08
Apr-08
Jul-08
Oct-08
Source: Bloomberg
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3 January 2012
Insurersdecline on EV and BV owing to investments

(Rmb m) China Life Ping An CPIC China Taiping PICC P&C 2008 Invt variance/ EV (%) (13.3) (10.8) (12.0) (6.4) n.a. % chg in EV (4.9) (18.3) (6.4) 24.3 n.a. % chg in BV (Dec-08 vs. Dec-07) (12.0) (24.7) (17.4) (10.6) (16.4)
premium recognition ratio). That said, most life insurers (except Ping An) have seen VNB grow much faster than total premium growth and the first-yearpremium growth, suggesting an improvement in the quality of the business this year.
Source: Company, Daiwa Note 1: Figures for Taiping Life are in HK$m Note 2: Book values are under the old accounting standard for consistency
P&C a record year for underwriting, but will it last?

P&C premium growth remains solid despite the high base effect of 2010 and slow new car sales in China this year. Insurers have been practising selective underwriting, exploring non-auto businesses and expanding direct sales-marketing channels. On the underwriting side, 2011 has been a record year for the P&C insurers as they continue to see underwriting profit, even at the industry level.
Insurers: premium and VNB growth (1H11)
(Rmb m) China Life Ping An Life CPIC Life Taiping Life PICC P&C Ping An P&C CPIC P&C Taiping Insurance 1H10 183,614 54,888 48,959 21,290 81,628 30,191 27,107 4,417 Total premiums 1H11 % chg YoY 195,490 6.5 75,158 36.9 54,574 11.5 21,114 (0.8) 91,444 12.0 40,922 35.5 32,301 19.2 3,967 (10.2) 1H10 11,548 8,603 3,238 1,055 VNB 1H11 % chg YoY 12,186 5.5 10,148 18.0 3,830 18.3 1,253 18.8
Earnings China Lifes were the most resilient in 2008

China Life (2628 HK, HK$18.7, Outperform[2]) demonstrated its resilience in the previous crisis with the smallest YoY decline in net profit, although the companys cuts in claims and reserve ratios were much lower than those of Ping An.
Insurers: net-profit comparison (2007 vs. 2008)
(Rmb m) China Life Ping An CPIC China Taiping PICC P&C % chg in NEP 20.9 20.5 21.9 37.2 18.0 2007 vs. 2008 % chg invt income (61.4) n.a. (70.2) (95.8) (47.4) % chg in net profit (45.3) (98.6) (72.5) n.a. (98.3)
Source: Company, Daiwa Note 1: Figures for Taiping Life are in HK$m Note 2: All numbers are under the old accounting standard for consistency Note 3: Ping Ans investment income dropped from Rmb52.8bn in 2007 to a loss of Rmb7.4bn due to an impairment on the Fortis (now known as Ageas) investment Note 4: Net profit of China Taiping dropped from HK$2.5bn in 2007 to a net loss of HK$299.7m mainly from losses from its pensions and asset-management businesses
Source: Company, Daiwa Note 1: Figures for Taiping Life are in HK$m Note 2: Premium numbers are from the companies and not from the CIRC to avoid the distortion of the new accounting standard adopted in the 2011 numbers
Valuation from peak to trough

Based on the 2007 Bloomberg-consensus forecasts, the one-year-forward average new business multiple (NBM) for the life insurers fell from about 70x to 1.0x (a mean of about 25.0x since 2003), while the average PEV fell from 4.5x to 1.2x (a mean of about 2.5x since 2003).
Investments losses from equity investments should be smaller this time

In 2011, short-term interest rates have been very high given the tight liquidity environment, and bond yields in China have been largely flat; while the A-share market has fallen by about 20% YTD (mainly in October). As a result, we expect the insurers to see strong interest income from negotiated deposits and solid dividends from equity funds that performed strongly in 2010. However, from the EV/BV perspective, insurers may see markdowns in both bond and equity investments, although their equity positions are much lower now than in 2008-09.
Insurers: investment portfolios (June 2011)
(Rmb m) China Life Ping An CPIC China Taiping PICC P&C Equity & funds 194,624 101,599 61,145 18,334 25,763 Jun-11 Bonds Total investments 674,479 1,414,568 553,217 883,550 265,573 490,513 104,738 166,279 101,137 185,383 Equity & funds as a % of total 13.8 11.5 12.5 11.0 13.9
Where are we now?

Life premium growth has been slow but quality has improved
Today, the operating environment for the insurers is totally different, in that we see premium growth as the real concern. It is probably also the first time that the China insurers have started to realise that newbusiness growth can be a problem and they should not take it for granted. For 1H11, the overall China lifeinsurance industry saw a 5.1% YoY decline in premiums. Even stripping out the impact of the change in accounting standards, the big listed players saw a significant slowdown in premium growth (except Ping An, which has shifted from selling universal life policies to participating [PAR] policies that have a higher
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3 January 2012
Insurers:EV and BV comparison

(Rmb m) China Life Ping An CPIC China Taiping PICC P&C 1H11 % chg in EV % chg in BV (0.5) (5.5) 16.4 19.3 (0.1) (0.6) 9.1 1.1 n.a. 15.0 2011E Invt variance/ EV % chg in BV (7.89) (12.7) (7.92) 10.5 (5.75) 1.1 (4.13) (0.4) n.a. 17.4
Valuation we have now experienced a new trough for the life insurers
This time round, the average one-year forward-rolling NBM has fallen from about 30x to 0.8x (at some point, the NBM for Ping An, CPIC and China Life were all below zero), while the average PEV has fallen from 2.9x to 1.1x.
China: interest rate and bond yield (2011)

(%) 4 3 2 1 0 Jan-10

Headwinds likely to remain near term
Unlike the market view, we are more cautious on the outlook for the China insurers in 2012. Many people interpret the recent RRR cut as the beginning of monetary loosening; and expect that life-premium growth momentum will accelerate soon as the slow growth this year has largely resulted from the tight liquidity environment. We expect top-line premium growth for 2012 to be better than this year given the low base effect; but we believe it will take time (ie, at least 6-9 months) for insurance demand to return even after the loosening. Nonetheless, we believe premium growth will continue to be a longer-term concern given the homogenous nature of the insurers products. Currently, we see the products sold by the China insurers, regardless of whether they are PAR or universal life, as being easily substituted by bank deposits or wealth-management products (which offer higher returns). Moreover, the focus on savings/investment products has limited the room for a VNB-margin improvement for the insurers going forward, and we see this as a growth bottleneck for the development of the industry. Another long-term challenge we see for the insurers is bancassurance distribution. We believe in 5-10 years time, China will follow the path of many other countries and that there will be strong growth in the bancassurance business. However, we see this coming mostly from the bank-owned insurers (such as HSBC in Hong Kong or Bangkok Life in Thailand) or exclusive distribution agreements between large banks and large insurance companies (such as Prudential and Standard Chartered in Asia), and not the current non-exclusive distribution arrangements found currently in China.
Jul-10 PBOC 1-yr benchmark rate China 10-yr govt bond yield
Jan-11
Jul-11
China 5-yr govt bond yield
Source: CEIC, Bloomberg
SHSZ300 CSI Index performance (2011)

4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 Jan-11 Mar-11 May-11 Jul-11 Sep-11
Source: Bloomberg
Earnings China Life likely to take the worst hit being a pure life insurer
Contrary to what we saw in the previous cycle, we expect China Lifes earnings to take the biggest hit this time, as the other players are cushioned by their strong P&C underwriting performance this year.
Insurers: net-profit comparison (2010 vs. 2011)
1H10 vs. 1H11 2010 vs. 2011E % chg in % chg in invt % chg in % chg in % chg in invt % chg in (Rmb m) NEP income net profit NEP income net profit China Life 6.1 2.3 (28.1) 3.4 1.2 (31.0) Ping An 38.6 45.9 32.7 31.5 6.3 33.0 CPIC 18.9 11.6 44.7 16.4 2.1 9.0 China Taiping 0.4 26.5 20.3 (1.2) 20.9 (33.3) PICC P&C 14.3 42.6 99.6 6.7 (2.2) 74.2
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3 January 2012
Thematic pick: CPIC

Although we are cautious on the near-term outlook of the China insurers, we see their current valuations as being appealing for long-term investors. This is not from the perspective of a relative basis versus historical valuation range (because it is a different time now), but more on an absolute basis, given that we believe the share prices of many of the insurers have factored in very little new-business growth. Our top pick in the sector is CPIC, as we believe the company offers the strongest VNB-growth prospects and that this growth will be of a high quality and sustainable.
3.0%. We have used the companys discount rate of 11.5% and assume no improvement in the VNB margin. We value the P&C insurance business based on a Gordon Growth Model. Out target PBR of 1.59x for 2011 assumes a sustainable ROE of 16.5%, a terminal growth rate of 3.0%, and a COE of 11.5%. We apply a 50% discount to the book value at the holding-company level.
CPIC: valuation summary
Life business EVPS - Life VNBPS New business multiplier (x) P&C business BVPS PBR (x) Others BVPS PBR (x) Fair value (HK$)
Why Buy CPIC?
Stronger-than-peers VNB growth as its product mix and agent productivity continue to improve. Superior P&C underwriting track record (both good and bad market environments). Best solvency ratio. Potential launch of tax-deferrable pension pilot scheme could be a share-price catalyst.
2011E 36.69 10.91 0.99 26.04x 4.47 2.82 1.59x 1.99 3.97 0.50x 43.15
2012E 44.22 14.09 1.26 23.85x 5.75 3.62 1.59x 2.22 4.44 0.50x 52.19
Catalysts
We believe the potential launch of a tax-deferrable pension pilot scheme by the China Insurance Regulatory Commission in Shanghai would be a catalyst for a rerating of CPIC, given the companys strong presence in the citys pensions market.
Valuation
Our six-month target price is HK$43.15, based on our SOTP valuation, which comprises three parts: life insurance, P&C insurance, and other business. The appraisal value of the life-insurance business is equal to 2011E embedded value + 2011E value of new business * NBM. Our 2011E NBM is 26.04x, based on a three-stage growth model with a new-business forecast of 12.5% YoY for 2014 diminishing to a terminal growth rate of
Insurance: target prices
Company China Pacific Ping An China Taiping PICC P&C
Risks
Like its peers, CPIC is subject to risks from a possible correction in the A-share market, not only because it has investments there, but also because the market considers the insurers as a proxy for the A-share market.
Bloomberg code 2601 HK 2318 HK 966 HK 2328 HK
Share price Six-month Upside/downside 19-Dec-11 target price potential 2012E PER (local curr.) (local curr.) (%) (x) Valuation basis 20.90 43.15 106.5 11.45 SOTP basis. Life at 26.04x NBM and P&C at 1.59x P/B. 53.45 100.31 87.7 11.22 SOTP basis. Life at 22.78x NBM; P&C at 1.50x P/B; Bank at 1.38x P/B and Securities at 1.25x P/B. 14.94 25.40 70.0 11.80 SOTP basis. Life at 24.02x NBM; P&C at 1.53x P/B and Reinsurance at 1.53x P/B. 10.32 8.96 (13.2) 9.20 2.60x P/B.
Insurance: valuation summary

Company China Pacific Ping An China Taiping PICC P&C Bloomberg code 2601 HK 2318 HK 966 HK 2328 HK Share price 19-Dec-11 (local curr.) Rating 20.90 Buy 53.45 Buy 14.94 Buy 10.32 Underperform Six-month target price (local curr.) 43.15 100.31 25.40 8.96 +/- Year (%) end 106.5 Dec 87.7 Dec 70.0 Dec (13.2) Dec 2010 17.9 20.1 11.3 18.8 PER (x) 2011E 2012E 15.5 11.4 14.9 11.2 17.0 11.8 11.1 9.2 EPS growth (% YoY) 2010 2011E 2012E 13.1 14.9 36.0 23.8 34.8 33.0 149.4 (33.4) 44.2 205.5 69.1 20.9 PBR (x) 2010 2011E 1.91 1.80 3.11 2.79 2.00 2.10 3.68 2.99 ROE (%) 2010 2011E 11.0 11.6 17.6 19.6 19.5 12.0 21.6 29.1 Dvd Yield (% p.a.) 2010 2011E 2.2 1.6 0.9 0.7 0.0 0.0 0.0 2.7
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3 January 2012
China oil demand: growth in 2008

Although Chinas oil demand also decelerated compared with 2007, it nevertheless recorded 1.5% YoY growth for 2008 compared with the previous five-year average of 8.3% YoY. As can be seen in the following chart, Chinas crude-oil imports did not dip in 2008 and remained steady over the course of that year, despite the financial crisis that roiled the global markets.
China: monthly crude-oil imports 2008-11 (three-month moving average)
(m tonnes) 24 22 20 18 16 14 12 Jan Feb Mar Apr May 2009 Jun Jul Aug 2010 Sep Oct Nov 2011 Dec 2008
Source: Dow Jones
Oil & Gas Neutral

Adrian Loh (65) 6499 6548 (adrian.loh@sg.daiwacm.com)

Oil demand decelerated
The global financial crisis in 2008, and ensuing deep economic contraction, caused OECD oil demand to decline by 3% YoY and 4% YoY for 2008 and 2009, respectively. This resulted in respective 0.5% YoY and 1.5% YoY declines in global oil demand for the two years. In the Asia-Pacific region, oil demand did not fall as precipitously, declining by only 0.1% YoY for 2008 against an average 3.2% YoY growth rate for the five years before that.
Annual oil demand growth: OECD vs. China
20% 15% 10% 5% 0% (5%) (10%)
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
China: oil-demand growth vs. GDP growth

(% YoY) 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% (2%)
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
15% 10% 5% 0%
OECD
Source: BP Energy Review 2011
China
GDP
Source: BP Energy Review 2011, Bloomberg
Oil demand growth
On an absolute basis, 2008 saw a 0.43mmbpd loss in oil demand and this, combined with the unwinding of oil futures contracts, resulted in the oil price plummeting by more than 70% over a six-month period starting from July 2008. Interestingly, although oil demand contracted by a further 1.29mmbpd in 2009, the WTI oil price rose by 71% during the year. We believe this was the result of: 1) an improving outlook heading into 2010, and 2) the oil price having fallen far below the equilibrium level necessary to sustain supply in 2H08.
No stopping Chinas refining capacity growth

China: refining-capacity growth
('000 bpd) 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 (% p.a.) 20%
Source: BP Energy Review 2011, Daiwa forecasts
- 61 -
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011E 2012E 2013E
Capacity (LHS) Growth p.a. (RHS)

3 January 2012
As can be seen from the preceding chart, Chinas refining capacity has expanded steadily over the past 10 years (2001-10), averaging 6.5% YoY growth. While there was a mild dip in 2008 to 3.8% YoY growth, we argue that this was not meaningful and was caused by project schedules given that refineries take 3-4 years to construct rather than global or domestic oildemand issues.
This lack of spare capacity could be one of the key factors to hold oil prices up at higher-than-expected levels in 2012, while the continued high open interest in oil futures could lead to the levels of oil-price volatility previously seen in 2008, should global economic conditions worsen from here.
EPS-forecast cuts in 2008

Bloomberg-consensus EPS-forecast cuts in 2008 affected Sinopec the most, with a 68% peak-to-trough revision. Interestingly, the EPS downgrades in 2009 were relatively uniform across the three China oil plays despite their different business models.
EPS revisions for the China oil plays from peak to trough
0% (10%) (20%) (30%) (40%) (50%) (60%) (70%) (80%) PetroChina -68% Sinopec 2008
Source: Bloomberg
Oil-price volatility increased significantly

On the oil-price front, price movements in 2008 were exacerbated by massive direct and indirect money flows by financial markets (often referred to as noncommercial players, instead of the traditional commercial players such as oil companies) looking to gain exposure to commodity markets. The absence of a cap on speculative activity, combined with ready access to high levels of leverage, compounded the rise and subsequent fall in oil prices in 2H08.
NYMEX crude oil light sweet total open interest futures only (three-month moving average)
(No. of contracts) 1,800,000 1,600,000 1,400,000 1,200,000 1,000,000 800,000 600,000 Jan-05
-30%
-29%
-30%
-27%
-27%
CNOOC
2009
Where are we now?

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
Source: U.S. Commodity Futures Trading Commission
Interestingly, we have recently seen open interest in oil futures surpass (and come off) the peak seen in 2H07. In addition, we point out that OPEC spare capacity appears to be heading towards the same low levels that occurred in 2008.
Brent oil price vs. OPEC spare capacity
(US$/bbl) 140 120 100 80 60 40 20 0 (mmbpd) 6 5 4 3 2 1 0
We believe the fundamentals in the oil and gas sector remain largely the same as they were during the global financial crisis. In our view, oil-supply issues are still prevalent, and although global oil demand may face some destruction, we highlight the ability of geopolitical risk being a key risk factor that could drive oil prices up.
Deregulation in China
We appear to be closer to downstream deregulation (in that the companies now have been given the power to adjust their own fuel pricing). However, we still believe the government will remain watchful, given the ability of high energy prices to adversely affect economic growth. Thus, product-price movements may still not reflect international market prices, implying that PetroChina and Sinopec may still have to bear some level of subsidy burden. Gas-pricing reform is certainly possible in 2012 (we give it a 50:50 chance), mainly because there have been so many leaked articles about it from the National Development and Reform Commission (NDRC). The main impetus for gas-pricing reform is to further - 62 -
1Q07
1Q08
1Q09
1Q10
1Q11
2Q
3Q
4Q
2Q
3Q
4Q
2Q
3Q
4Q
2Q
3Q
4Q
2Q
Brent oil price (LHS)

Source: EIA Short Term Energy Outlook
OPEC spare capacity (RHS)
3Q

3 January 2012
encourage gas exploration and cover losses from natural gas imports (the latter of which only PetroChina suffers from, not Sinopec or CNOOC). Note that, at current gas prices, it is still very economic to explore for gas, but obviously higher prices may encourage more exploration. On a more interesting note (and perhaps an argument as to why gas-price reform may not occur), gas prices in the US are 3040% cheaper than in China, due to the ever-higher levels of shale gas coming out of that country. China has already started shale-gas exploration and could be a major producer in a few years, which could drive gas prices down as it has in the US.
China Oil & Gas Sector: return on average equity

30% 25% 20% 15% 10% 5% 0% 2007 2008 2009 2010 Sinopec 2011E 2012E CNOOC 2013E PetroChina
Source: Companies, Daiwa estimates
Trends in profit margins and returns

Currently, we do not expect to see a meaningful contraction in EBIT-margin forecasts for the three China oil majors in 2011 and 2012. We note that both PetroChina and Sinopec experienced large declines in EBIT margins in 2008; however, the latter saw its margin rebound materially off a low base the following year. It was notable that CNOOCs return on average equity (ROAE) was inversely correlated to Sinopecs in the 2007-09 period. CNOOCs profit in 2008 was held up by the very strong oil prices seen in 1H08, while its 2009 profit was lower YoY on aggregate. Thus, its returns, even on a flat YoY equity base, looked poorer and declined to less than 20% YoY. Following 2009 however, its ROAE has returned to above the 20% level, and we forecast it to remain at this level, barring another large oil-price decline. At present, we do not see emerging stress at the sector or company levels in China. None of the three China oil majors are highly geared, and even though we forecast Sinopec to have the highest net gearing, at 22%, for 2011, we expect this to decline over the following two years. Thus, we expect the three companies to continue on their respective M&A paths internationally.
China Oil & Gas Sector: EBIT margin comparison
50% 40% 30% 20% 10% 0% 2007 2008 2009 2010 Sinopec 2011E 2012E CNOOC 2013E PetroChina

Status quo on oil-price forecasts
Based on our current ratings, we believe share-price performances will mirror those seen during the global financial crisis, with PetroChina and Sinopec performing in line with the market and CNOOC outperforming. We do not think oil prices will engender the same level of outperformance as they did in 2008-09, given that we do not believe oil prices can go materially above the current US$100/bbl level. Our 2012 Brent and WTI oil-price forecasts (see following table) do not currently price in a global or China economic recession. OPECs spare capacity remains reasonably thin at 2.5mmbpd currently, and thus if there is a further economic slowdown, oil prices are not likely to fall meaningfully.
Daiwa oil-price forecasts vs. NYMEX futures oil price
(US$/bbl) Brent oil price WTI oil price NYMEX WTI futures
2012E 105.00 95.00 100.92
2013E 107.00 100.00 97.05
2014E 107.00 100.00 93.87
China oil demand should continue to grow in 2012 and beyond

For 2011-13, we forecast continued China refining capacity additions, with a total of 2.2mmbpd of new refining capacity going into operation. Assuming a minimum 70% capacity-utilisation rate, this means that the demand pull from these new refineries could see Chinas oil demand increase by at least 1.54mmbpd over the same period. Thus, just based on refiningcapacity additions, we forecast the countrys oil demand to hit 10.6mmbpd by 2013, representing a CAGR of 5.4% from 9.01mmbpd for 2010.
- 63 -

3 January 2012
M&A opportunities
As noted earlier, none of the three China majors are significantly indebted; the worst is Sinopec we forecast it to have a net gearing of 22% as at the end of 2011. This should allow all three companies to continue to sail forth and acquire oil and gas assets overseas. As can be seen from the following chart, the value of M&A transactions dipped in both 2007 and 2008; however, it has since resumed its upward trajectory.
China: upstream transaction value outside home country
(US$bn) 30 25 20 15 10 5 0 2003 2004 2005 CNPC CNOOC 2006 2007 2008 2009 Sinopec Corp CITIC 2010 PetroChina Sinochem
Source: IHS Herold
Thematic pick: CNOOC

We like COOC because of its strong management, production-growth profile, and exposure to offshore China, which remains underexplored, in our view. The incremental news flow for the company appears more positive than three months ago as projects have come onstream or are coming back on line after shutdowns. On the valuation front, the stock is still trading at a 2012E PER discount to PetroChina, which is abnormal given that over the past decade the former has tended to trade at least one PER multiple point above PetroChina. At CNOOCs current share price, the stock implies a crude-oil price of about US$60/bbl.
Nearly US$70bn Nearly US$70bn spent by spent by Chinese China national oil national and companies oil its companies and fund in sovereign wealth its thesovereign weath fund past eight years in the past eight

Our DCF/PER-based six-month target price for CNOOC is HK$21.50. Our PER valuation is HK$20.05, which uses a target PER of 11x. This equates to a 10% discount to the companys average 2003-10 PER of 12.1x, which we believe is fair given that our forecast production-growth profiles for 2011 and 2012 will be below the companys five-year (2005-10) production CAGR of 16%. Our DCF-based NAV of HK$22.87 uses a long-term oil price of US$95/bbl and a WACC of 9.8%. The risks to our target price and rating would include falling commodity prices and operational risks relating to the extraction of oil and gas. Share-price catalysts for the stock in 2012 would include its production and capex guidance at its strategic briefing in late January, pilot production at its Eagle Ford Shale in Texas (likely in 2H12), and the resumption of production at the Penglai 19-3 oil field.
Sinopec Group CIC
Total global upstream transaction value and deal count

(US$bn) 250 200 150 100 50 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 400 300 200 100 0
Asset-transaction value (LHS) Deal count (RHS)

Source: IHS Herold
Corporate-transaction value (LHS)
Oil & Gas: target prices

Company CNOOC PetroChina Sinopec
Bloomberg code 883 HK 857 HK 386 HK
Share price Six-month Upside/downside 19-Dec-11 target price potential 2012E PER (local curr.) (local curr.) (%) (x) Valuation basis 13.58 21.50 58.3 7.7 Average of DCF and target PER of 11x on 2012 EPS 8.99 9.00 0.1 8.1 Target PER of 7.9x on 2012 EPS 7.98 7.30 (8.5) 7.7 Target PER of 7.0x on 2012 EPS
Oil & Gas: valuation summary

Company CNOOC PetroChina Sinopec
Share price Bloomberg 19-Dec-11 code (local curr.) 883 HK 13.58 857 HK 8.99 386 HK 7.98
Rating Buy Hold Hold
Six-month target price (local curr.) 21.50 9.00 7.30
+/(%) 58.3 0.1 (8.5)
PER EV/EBITDA Dividend yield Year (x) (x) (%) end 2010 2011E 2012E 2013E 2010 2011E 2012E 2013E 2010 2011E 2012E 2013E Dec 9.1 7.9 7.7 7.1 4.6 4.0 3.7 3.2 3.6 4.4 4.6 4.9 Dec 9.5 9.1 8.1 7.3 5.5 5.0 4.4 4.0 4.2 4.4 5.0 5.6 Dec 7.8 7.2 7.7 7.0 4.6 4.2 4.1 3.7 2.9 3.1 2.9 3.2
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3 January 2012
China IPPs: quarterly EBIT margin (1Q08-3Q11)

(%) 16 14 12 10 8 6 4 2 0 (2) (4) (6) 11.9 9.4 12.9 14.3 12.0 8.4 10.2 10.1 7.9 7.0 9.6 7.0
Power and Power Equipment Neutral

Dave Dai, CFA (852) 2848 4068 (dave.dai@hk.daiwacm.com)
0.3 (0.6) (3.5)

1QO9 1Q08 2Q08 3Q08 4Q08 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11

Power-demand destruction and capacityinvestment delays
The China IPPs had a very difficult time in 2008, with the slowdown in the economy resulting in power consumption turning negative YoY. Meanwhile, a sharp rise in the spot coal price (which increased by 87% followed rapidly by a 41% crash over a period of eight months for 2008 for Qinhuangdao Datong mixed blend 5,800kcal) led the IPPs to see losses at the EBIT level for 2H08. As a result, the Bloomberg-consensus 2009 earnings forecast was cut by 41% and the PBR valuation contracted by 54% for the China IPP Sector during the 2008 financial crisis. In 2009, however, the IPPs earnings rebounded significantly following a correction in coal prices.
Quarterly GDP (YoY change) and power demand (YoY change)
(%) 30 25 20 15 10 5 0 (5) (10)
1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11
Source: Companies Note: EBIT margin presented is aggregate EBIT divided by aggregate revenue; companies include Huaneng Power (HNP), Datang Power (DTP), and Huadian Power (HDP)
IPPs: consensus net-profit forecasts during 2H08

5,000 4,000 3,000 2,000 1,000 0 (1,000) Jan-08
Mar-08
May-08 2008
Jul-08 2009
Sep-08
Nov-08
Source: Bloomberg
Power demand turned negative YoY when quarterly GDP fell to 7.6% YoY
Power consumption
Source: CEIC
Quarterly GDP
For 2H08, when the IPPs recorded unprecedented losses and saw declining power demand, the powerequipment companies, such as Shanghai Electric (SHE), Dongfang Electric (DEC) and Harbin Electric (HPE), revised down their production schedules for the following year, guiding for declines of 10-15% YoY for 2009 thermal-equipment production (the actual production decline was 10.4% YoY for the sector). A sharp rise in raw-material prices in 2007 added to the pressure on earnings in 2008. For 2008, the average gross-profit margin of the sector declined by 2.1pp YoY to 15.3%, and was followed by another fall, of 0.5pp YoY for 2009.
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3 January 2012
Power-equipment makers: consensus net-profit forecasts during 2H08

3,000 2,800 2,600 2,400 2,200 2,000 1,800
The usual four factors 1) power demand, 2) coal prices, 3) interest rates, and 4) tariffs will continue to affect the IPPs profitability.
EPS sensitivity to variables (2012E)
Sensitivity analysis 1% increase in coal costs 1% increase in tariffs 25bp lending-rate hike 1% increase in utilisation hours
CRP (5.2) 7.6 (2.3) 2.3
CPI (5.3) 10.2 (4.9) 1.6
DTP (6.8) 10.4 (5.1) 3.6
HNP (16.3) 24.2 (6.1) 4.0
HDP (33.3) 43.1 (16.3) 8.8
Jul-08
Jan-08
May-08
Feb-08
Mar-08
Jun-08
Aug-08
Sep-08
Oct-08
Nov-08
Dec-08
Apr-08
2008
Source: Bloomberg
2009
Where are we now?

With inflation easing, China raised on-grid power tariffs by 2.5 fen/KWh across the board on 1 December 2011, which should help the struggling IPPs recover some profitability from 1H12. However, the earnings recovery is unlikely to be strong enough for the IPPs to see a reasonable return for utilities companies, as we expect EBITDA margins and ROE to be far below pre2008 levels. Even in the year of an earnings recovery, such as 2009, the sector failed to record a positive absolute or relative performance. Over the past few years, the power-equipment companies have changed their product mix, such that they are less reliant on traditional thermal products and more focused on new energy fields (hydro, wind, and nuclear power). We believe a diversified product mix limits the exposure of the companies to the financial difficulties at downstream IPPs in economic downturns, and thus should support future earnings, which reduces the risk of a valuation derating.
Coal price likely to remain stable this time Daiwas thermal coal analyst, Felix Lam, forecasts a 2% YoY decline in the spot coal price and a 5% YoY rise in contract prices for 2012, following the NDRCs announcement that it was intervening in coal prices on 30 November 2011. As we do not expect a sharp fall in coal prices similar to what happened in 2H08, we forecast only a mild earnings recovery for the IPPs in 2012. Any rate cuts could help more this time. Daiwa believes there will be no fall in interest rates over 2012. However, an earlier-than-expected lowering could lead to a fast turnaround in the earnings of the IPPs. The IPPs EBIT interest coverage ratio stands currently at 1.7x, at an all-time low level excluding the record losses in 2008. This makes earnings much more sensitive to changes in finance costs than in previous cycles.
IPPs: EBIT interest coverage ratio
(x) 6 5 4 3 2 1 0 2005 2006 2007 2008 2009 2010
Source: Companies
5.6
5.2
3.7
2.1
1.7

China IPPs
Following the increase in the on-grid power tariff by 2.5 fen/KWh in December 2011, we expect the IPPs to see an earnings recovery in 2012, as the tariff increase should be more than enough to offset our projected 5% YoY rise in blended coal costs for 2012. With profit having been hit by rising coal prices and rising interest rates in 2011, we forecast the IPPs to see their average ROE recover from 6.7% in 2011 to 7.5% in 2012, which is below the pre-2008 level (but a reasonable return for utilities, in our opinion).
0.4
Tariffs could be cut if profits recovered too quickly. We cannot exclude the possibility of history repeating itself, such that tariffs could be reduced if profits recovered too quickly. In November 2009, given the wide range in profitability, the NDRC made the unusual decision to raise tariffs for power plants inland and reduce the tariffs of those on the countrys coast.
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3 January 2012
China: spot coal prices and power prices

(Rmb/t) 1,000 900 800 700 600 500 400 300 200 100 0 (Rmb/KWh) 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0
China: power-shortage projections by the government

(GW) 80 70 60 50 40 30 20 10 0 20 25 18 9 5 0 0 45 40 30 50
70
1H04
2H04
1H05
2H05
1H06
2H06
1H07
2H07
1H08
2H08
1H09
2H09
1H10
2H10
2011E
2012E Jul-11 Apr-11
End-user tariff (RHS)

Source: CCTD, NDRC, compiled by Daiwa
Source: China Electricity Council
China power-equipment suppliers

Compared with 2008, Chinas power-equipment companies exposure to thermal products is much lower currently, given their increased focus on newenergy products. We forecast the proportion of gross profit that thermal equipment accounts for to decline from 67% for 2008 to 53% for 2012. We believe a possible upward revision of the gas-fired power capacity target by 2015 and the resumption of approvals for nuclear-power projects will serve as earnings growth drivers and share-price catalysts.
Power-equipment companies: gross-profit contribution from thermal power equipment
Thermal/total gross profit (%) DEC SHE HPE Average 2008 83.9 41.7 75.9 67.2 2009 73.1 39.2 70.2 60.8 2010 60.2 37.6 61.6 53.1 2011E 61.8 34.5 65.8 54.0 2012E 62.6 35.5 60.1 52.7 2013E 61.7 34.3 58.5 51.5
Cost pressure likely to ease in 2012. Unlike in the last difficult cycle in 2008, when the steel price was at a record high and had a significant negative impact on the gross-profit margins of the powerequipment companies, Daiwas head of Asia-Pacific Metals and Mining, Alexander Latzer, forecasts Chinas flat-steel price to see a 5.5% YoY drop in 2012, which should reduce the risk of downward earnings revisions this time.
China: steel spot price
(Rmb/t) 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 Roller-coaster ride during 2008 Stable and declining over the past 12 months
Power shortage could be less serious, but still a need for more capacity. Earlier this year, the China Electricity Council predicted peak-demand power shortfalls of 30GW, 50GW, and 70GW for 2011, 2012, and 2013, respectively. Although we have seen power demand in China slow along with the economy, we still expect the real power-capacity shortages in coastal provinces (Jiangsu, Zhejiang and Guangdong) to continue throughout 2012, which should support new orders for the power-equipment makers, and therefore the visibility and sustainability of their earnings over the next two years.
Jul-08
Jul-09
Oct-08
Oct-09
Jul-10
Oct-10
Jan-09
Jan-10
Source: CU Steel
Among the IPPs, companies that pursue a verticalintegration strategy (power and coal) could be more immune to volatility in fuel costs, such as China Resources Power, while pure thermal plays such as HNP and HDP are more sensitive to variables such as power tariffs, coal costs, and interest rates. Among the power-equipment companies, SHE is best-positioned, in our view, given that it has the smallest earnings exposure to thermal equipment and the advances it has made in the nuclear Gen-III technology, AP1000.
- 67 -
Jan-11
Jan-08
Oct-11
Apr-08
Apr-09
Apr-10
2013E
2002
2003
2004
2005
2006
2007
2008
2009
2010
Datong coal price (LHS)
On-grid tariff (RHS)
1H11

3 January 2012
Thematic picks: Shanghai Electric and Harbin Electric

SHE is our top pick in the China Power and Power Equipment Sectors given its balanced product mix (it has the smallest earnings exposure to thermal products among its peers) and sustainable earnings growth: we forecast a CAGR of 18.5% over 2011-13. This is underpinned by our belief that AP1000 nuclear technology will remain the main focus of Chinas nuclear-power development, and SHE is the undisputed leader in this field. We also like HPE for the earnings upside in its nuclear business, which we expect to turn profitable in 2013. We believe the market does not regard HPE as a nuclear-power proxy, and that the current appealing valuations (2012 PER of 6.1x, and a 2012 PBR of 0.7x, both based on our forecasts) have not factored in future earnings growth from nuclear-power products.
Power and Power Equipment: target prices
Company Harbin Electric Shanghai Electric China Resources Power Huaneng Power Dongfang Electric Datang Power Huadian Power China Power Int'l
Valuations and catalysts

Our PER-based six-month target price for SHE is HK$4.70, and the stock is trading currently at a PER of 9.5x on our 2012 EPS forecast and a PBR of 1.1x on our 2012 BVPS forecast, which we see as attractive given the earnings CAGR of 18.5% that we forecast over 201113. For HPE, our six-month target price, of HK$9.42, is based on a blended target PER of 9x on our 2012 EPS forecast. The stock is the cheapest among its peers in terms of forward PER, and is trading at a deep discount to its past-five-year average 12-month-forward PER. Share-price catalysts include China revising up its 2015 capacity target for gas-fired power and the resumption of approvals for nuclear-power projects, as well as the announcement of a long-term nuclear power capacity target. Investment risks include worse-than-expected revenue for the thermal-power business, especially from India.
Bloomberg code 1133 HK 2727 HK 836 HK 902 HK 1072 HK 991 HK 1071 HK 2380 HK
Share price Six-month Upside/downside 19-Dec-11 target price potential 2012E PER (local curr.) (local curr.) (%) (x) Valuation basis 42.5 6.1 PER (9x on 2012 EPS) 6.61 9.42 3.50 4.70 34.3 9.5 PER (13x on 2012 EPS) 14.00 18.00 28.6 11.3 NAV (1.9x PBR on 2012 BPS for power assets and DCF for coal) 4.05 4.57 12.8 14.1 PBR (1.0x on 2012 BPS) 21.95 25.20 14.8 12.1 PER (12x on 2012 EPS) 2.45 2.65 8.2 10.6 SOTP (0.7x PBR on 2012 BPS for power assets and DCF for non-power) 1.45 1.46 0.7 12.4 PBR (0.5x on 2012 BPS) 1.79 1.78 (0.6) 8.1 PBR (0.6x on 2012 BPS)
Power and Power Equipment: valuation summary

Bloomberg code 1133 HK 2727 HK 836 HK 902 HK 1072 HK 991 HK 1071 HK 2380 HK Share price Six-month 19-Dec-11 target price +/- Year (local curr.) Rating (local curr.) (%) end 6.61 Buy 9.42 42.5 Dec 3.50 Buy 4.70 34.3 Dec 14.00 Buy 18.00 28.6 Dec 4.05 Outperform 4.57 12.8 Dec 21.95 Hold 25.20 14.8 Dec 2.45 Hold 2.65 8.2 Dec 1.45 Hold 1.46 0.7 Dec 1.79 Hold 1.78 (0.6) Dec PER (x) 2011E 2012E 6.6 6.1 11.1 9.5 13.4 11.3 25 14.1 12.9 12.1 14.6 10.6 n.a. 12.4 10.3 8.1 PBR (x) 2011E 2012E 0.7 0.7 1.3 1.1 1.5 1.4 0.9 0.8 3 2.5 0.9 0.8 0.5 0.5 0.6 0.5 EV/EBITDA (x) 2010 2011E 2012E n.m. n.m. 0.2 4.2 3.3 1.9 10.4 8.8 7.2 9 9.4 8.3 8.4 8.2 6.3 10.3 10.5 9.2 14.1 11 8.6 11 8 7 Dividend yield (%) 2010 2011E 2012E 2.6 2.8 3.1 2.3 2.7 3.2 2.4 2.3 2.8 4.1 2.1 3.6 0.7 0.8 0.8 3.5 2.3 2.4 0 0 0.8 4 3.9 4.3
Company Harbin Electric Shanghai Electric China Resources Power Huaneng Power Dongfang Electric Datang Power Huadian Power China Power Int'l
2010 7.3 13 13.4 12.4 13.9 9.6 47.5 11.2
2010 0.8 1.3 1.6 0.8 3.3 0.8 0.5 0.6
- 68 -

3 January 2012
China: quarterly residential ASP

(Rmb/sq m) 6,000 5,000 35% 30% 25% 20% 15% 10% 5% 0% (5%) (10%)
Property Positive
Danny Bao, CFA (852) 2773 8715 (danny.bao@hk.daiwacm.com)
4,000 3,000 2,000 1,000 0

Physical market
Chinas credit tightening in 2H07 led to weak housing demand in 1H08. The global financial crisis in October 2008 also affected housing demand in the country. Total residential GFA sales declined by about 19% YoY to 559m sq m for 2008.
Residential GFA sales
(m sq m) 1,000 800 600 400 200 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011E 2012E GFA sales (LHS)
Source: Soufun, 2011-12 data based on Daiwa estimates
Source: Soufun
Consensus EPS forecast revisions

The IBES-consensus EPS-growth forecasts for the MSCI China trended down in 1H08. However, even after the global financial crisis, the consensuss 2008 EPS forecasts for the MSCI China Property Index were still too high. By comparison, the 2009 and 2010 EPSgrowth forecasts were too conservative. The actual EPS decline for 2008 was about 9% YoY. EPS growth was about 17.7% YoY for 2009 and 51.2% YoY for 2010.
Consensus EPS-growth forecasts for MSCI China Property (2008-10)
60 50 40 30 20 10 0 (10) (20)
60% 50% 40% 30% 20% 10% 0% (10%) (20%) (30%) % change (RHS)
Sep-06 Dec-06 Mar-07
4Q00 2Q01 4Q01 2Q02 4Q02 2Q03 4Q03 2Q04 4Q04 2Q05 4Q05 2Q06 4Q06 2Q07 4Q07 2Q08 4Q08 2Q09 4Q09 2Q10 4Q10 2Q11
Quarterly ASP (LHS) YoY change (RHS)
The quarterly residential selling price also declined, by about 5.5% YoY to Rmb3,585/sq m for 3Q08. For the full-year 2008, the average residential selling price only fell by about 0.28% YoY to about Rmb3,655/sq m. In 2009, lower interest rates and supportive government housing policies boosted housing demand and prices. Residential prices rebounded quickly, rising by 22.41% YoY to Rmb4,474/sq m for 2009. The GFA sold also increased, by 53% YoY to 853m sq m for the same year.
2008E EPS growth 2010E EPS growth

Source: MSCI
2009E EPS growth
Sector valuation
The MSCI China Property Index dropped to a low at the end of October 2008, following the deterioration in the physical market. The NAV discount bottomed out at about 72%, triggered by the global financial crisis and physical-market weakness. The sector valuation began to rebound at the beginning of 2009, driven by supportive government policies.
- 69 -
Sep-11
Jun-07
Jun-06
Jun-08
Jun-09
Jun-10
Mar-06
Jun-11

3 January 2012
MSCI China Property Index vs. MSCI China

350 300 250 200 150 100 50 0
Residential prices have also been quite resilient. For the first 10 months of 2011, the average selling price in China increased by about 5.1% YoY, while major coastal cities such as Beijing, Shanghai, Hangzhou and Nanjing saw modest price declines.
China and selected cities: YTD ASP
City China commodity housing China residential Beijing Shanghai Shenzhen Guangzhou Tianjin Chengdu Chongqing Hangzhou Wuhan Xian Qingdao Nanjing Dalian Suzhou Average
Source: Soufun
MSCI China
Source: MSCI
MSCI China Prop
Where are we now?

Physical market
The government has continued credit tightening in 2011. In addition, it has introduced the Home Purchase Restriction (HPR) scheme in about 46 cities. Developers are facing a significant credit crunch and are motivated to cut prices in order to accelerate cash flow. For the first 10 months of 2011, total residential transaction volume increased by about 9% YoY to 710m sq m. Most of the major coastal cities, such as Beijing, Shanghai, Hangzhou, and Qingdao, have seen YoY declines in GFA sales. We believe most of the salesvolume increase has comes from inland third- and fourth-tier cities. We forecast residential GFA sales to decline for November and December, and full-year GFA sales to be flat at 931m sq m.
China and selected cities: YTD GFA sales
City China commodity housing China residential Beijing Shanghai Shenzhen Guangzhou Tianjin Chengdu Chongqing Hangzhou Wuhan Xian Qingdao Nanjing Dalian Suzhou 14 cities average
Source: Soufun
Jan-Oct 11 ASP (Rmb/sq m) 5,502 5,054 17,558 14,153 20,217 11,112 8,543 6,291 4,603 13,048 6,886 5,888 7,332 8,582 8,023 9,114 10,096
YoY change (%) 7.7 5.1 (4.2) (7.8) 4.8 12.1 14.9 9.7 16.7 (8.5) 25.7 26.5 20.1 (3.9) 12.7 13.1 9.4
5/1/2006
9/1/2006
1/1/2007
5/1/2007
9/1/2007
1/1/2008
5/1/2008
9/1/2008
1/1/2009
5/1/2009
9/1/2009
1/1/2010
5/1/2010
9/1/2010
1/1/2011
5/1/2011
9/1/2011
Consensus EPS forecast revisions

The IBES-consensus 2012-13 EPS forecasts for the MSCI China have been relatively stable in 2011. We think the consensus 2012-13 earnings forecasts for the sector are likely to be revised down. However, we also believe the earnings-downside risk is priced in.
Consensus EPS-growth forecasts for MSCI China Property (2011-12)
50 40
Jan-Oct GFA sales (m m2) 796.5 709.7 7.0 11.4 3.2 8.1 10.1 17.5 29.9 4.7 6.5 12.4 7.2 5.3 6.2 7.9 9.8
YoY change (%) 10 9 (18) (15) (1) (2) 9 7 5 (21) (19) 10 (16) (8) 2 (8) (5)
30 20 10 0 (10) (20) 09-Feb 09-Jun 09-Oct 10-Feb 10-Jun 10-Oct 11-Feb 11-Jun 11-Oct
2011E EPS growth 2013E EPS growth

Source: MSCI
2012E EPS growth
Sector valuation
The sectors valuations fell sharply during August and September and have remained at low levels since. The China Property Sector has been trading at about a 60% discount to NAV since September this year. We believe this valuation has priced in a hard-landing scenario for the China property market.
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3 January 2012
NAV discount for property sector

100% 80% 60% 40% 20% 0% (20% ) (40% ) (60% ) (80% )
We forecast sales volume in first- and second-tier cities to drop by 15-20% YoY, and that for third- and fourthtier cities to decline by 5-10% YoY for 2012. Sales volume should be more resilient in third- and fourthtier cities, in our view.
Sales-volume forecasts (2012) (% change)
Tier-one cities Tier-two cities Tier-three cities Tier-four cities
Oct-07
Oct-08
Oct-09
Oct-10
Jan-08
Jan-09
Jan-10
Jan-11
Jan-07
China
Historical average
Oct-11
Apr-07
Apr-08
Apr-09
Apr-10
Apr-11
Share of total China market (%) 2012E volume change (% YoY) 5 (20) 20 (15) 50 (10) 15 (5)
Jul-07
Jul-08
Jul-09
Jul-10
Jul-11
Overweight developers with greater exposure to third- and fourth-tier cities

We see the residential-property bubble as being more evident in first-tier and coastal second-tier cities, in which the property price-cooling policy should have a greater impact. Home prices are still affordable in most third- and fourth-tier cities. Owner-occupier demand there remains intact, despite the HPR scheme. We recommend investors consider developers with affordable products and high exposure to third- and fourth-tier cities. We believe the key beneficiaries of this trend will be Evergrande Real Estate and China Overseas Grand Ocean.

Third- and fourth-tier cities are in better shape
We believe first- and second-tier cities generally have higher policy risks than other cities, due to higher home prices there and less owner-occupier demand. We estimate that these cities account for about 25% of the total market share in China. Third- and fourth-tier cities account for about 65% of Chinas total market share, and face only moderate-to-low policy risk. We expect future affordable housing supply to have a higher impact on the low-end segment in first- and second-tier cities. Meanwhile, we see the risk of competing affordable housing in third- and fourth-tier cities as moderate.
Matrix of potential demand and policy risk
Tier-1 Tier-2 Tier-3 Tier-4 Share of total China market (%) 2011E demand (m sq m) 5 46 20 185 50 462 15 139 Policy risk High High Moderate Low
Thematic pick: Evergrande Real Estate

Evergrande has a unique business model, which sees it quickly replicate similar but very well designed residential properties in second-, third-, and fourth-tier cities. Although its locations are mostly in suburban areas, we expect the companys affordable products to continue to attract owner-occupier buyers. We estimate that about 64% of its NAV is accounted for by its exposure to less-developed third- and fourth- tier cities and investment properties. Evergrandes diversified landbank makes the company less dependent on firstand second-tier cities. We expect the companys volume growth in 2011-13 to offset a modest grossprofit-margin contraction.
We believe home prices in low-tier cities are unlikely to drop by more than 20% in 2012 from current levels, as housing in these cities is more affordable and prices were lower to start with. We forecast home prices in the major coastal cities to fall by 15-30% YoY in 2012.
Home-price forecasts (2012) (YoY % change)
Tier-1 Tier-2 Tier-3 Tier-4
Low-end (15) (10) (5) (5)
Mid-range (25) (15) (10) (5)
High-end (30) (20) (15) (10)

We believe the current valuation is attractive, and that Evergrande is the best way for investors to gain exposure to low-tier cities in China. Our six-month target price of HK$5.00 is based on a 40% discount to our 2012 NAV forecast. Our respective 2011 and 2012 NAV forecasts are HK$8.90 and HK$8.30. Our target price implies a 2011E PER of 8.2x.
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3 January 2012
Our cash-flow study suggests the company will have limited liquidity needs over the next 18 months. It has secured about 67.4% of our 2012 development-revenue
Property: target prices
Company Renhe Franshion Evergrande Guangzhou R&F Yuexiu Property COGO China Vanke - B Coli Glorious SOHO Longfor Country Garden CR Land
forecast through contract sales. We see modest risks to our 2012 earnings forecast. The next catalyst for the share price could be the 2011 earnings results.
Bloomberg code 1387 HK 817 HK 3333 HK 2777 HK 123 HK 81 HK 200002 CH 688 HK 845 HK 410 HK 960 HK 2007 HK 1109 HK
Share price Six-month Upside/downside 19-Dec-11 target price potential 2012E PER (local curr.) (local curr.) (%) (x) Valuation basis 124.1 3.5 50% discount to 2012E NAV 0.87 1.95 1.39 2.5 79.9 6.9 35% discount to 2012E NAV 3.02 5.0 65.6 4.8 40% discount to 2012E NAV 6.22 9.8 57.6 3.9 50% discount to 2012E NAV 1.09 1.7 56.0 4.3 65% discount to 2012E NAV 5.91 8.3 40.4 4.4 30% discount to 2012E NAV 7.42 9.2 24.0 7.2 20% discount to 2012E NAV 13.84 16.4 18.5 8.7 60% discount to 2012E NAV 1.14 1.4 22.8 4.1 65% discount to 2012E NAV 5.24 6.0 14.5 6.2 30% discount to 2012E NAV 8.99 9.7 7.9 7.4 45% discount to 2012E NAV 2.87 3.0 4.5 7.4 40% discount to 2012E NAV 12.48 11.9 (4.6) 13.6 36% discount to 2012E NAV
Property: valuation summary

Company Renhe Franshion Evergrande Guangzhou R&F Yuexiu Property COGO China Vanke - B Coli Glorious SOHO Longfor Country Garden CR Land Bloomberg code 1387 HK 817 HK 3333 HK 2777 HK 123 HK 81 HK 200002 CH 688 HK 845 HK 410 HK 960 HK 2007 HK 1109 HK Share price Six-month 19-Dec-11 target price +/- Year (local curr.) Rating (local curr.) (%) end 0.87 Buy 1.95 124.1 Dec 1.39 Buy 2.5 79.9 Dec 3.02 Buy 5.0 65.6 Dec 6.22 Buy 9.8 57.6 Dec 1.09 Buy 1.7 56.0 Dec 5.91 Buy 8.3 40.4 Dec 7.42 Buy 9.2 24.0 Dec 13.84 Buy 16.4 18.5 Dec 1.14 Outperform 1.4 22.8 Dec 5.24 Hold 6.0 14.5 Dec 8.99 Hold 9.7 7.9 Dec 2.87 Hold 3.0 4.5 Dec 12.48 Hold 11.9 (4.6) Dec 2010 (9.5) (4.7) n.m . 57.6 361.2 n.m . 40.1 50.2 (11.8) 10.2 28.2 93.1 40.4 EPS growth (% YoY) 2011E 2012E 2013E 20.9 20.7 18.1 45.7 27.1 25.6 38.2 4.5 8.4 15.1 6.2 6.1 92.2 19.9 8.4 141.0 12.2 30.4 21.3 14.1 1.4 19.5 8.3 3.1 5.9 5.4 (5.7) (70.6) 240.3 22.8 55.0 30.4 4.1 9.7 12.6 5.9 9.5 1.0 7.7 2010 9.9 1.8 0.8 9.6 0.0 0.0 1.6 2.0 0.0 5.0 1.3 4.0 2.5 Dividend yield (% p.a.) 2011E 2012E 2013E 8.4 11.2 12.6 2.2 2.2 4.3 5.3 6.1 6.5 9.8 10.2 11.2 6.3 7.5 8.2 4.3 5.2 7.0 2.5 2.8 3.1 2.0 2.1 2.2 5.1 5.5 5.1 1.4 5.1 6.3 1.8 2.4 3.1 4.3 4.7 4.7 2.6 2.6 2.7 P/NAV (x) 2011E 2012E 0.2 0.2 0.4 0.4 0.3 0.4 0.3 0.3 0.2 0.2 0.6 0.5 0.6 0.6 0.6 0.7 0.3 0.3 0.6 0.6 0.5 0.5 0.5 0.6 0.6 0.7 P/BVPS (x) 2011E 2012E 1.1 0.9 0.7 0.6 1.5 1.2 0.8 0.7 0.4 0.4 2.3 1.6 1.3 1.2 1.6 1.4 0.5 0.4 1.1 1.0 2.0 1.6 1.3 1.0 1.5 1.4
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3 January 2012
Solar Neutral
Pranab Kumar Sarmah, CFA (852) 2848 4441 (pranab.sarmah@hk.daiwacm.com)
Share-price performance. Despite the sound fundamentals, the high-beta solar index lost 60% of its value between September and December 2008, and underperformed the Nasdaq and the FTSE Global Energy Index.
Solar-product prices
(US$/kg) 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11
(US$/W) 500 400 300 200 100 0

4Q11
Aug-11 Dec-11

China benefitted from an acceleration of production outsourcing
Spain broke up the party in late 2008. In early 2008, polysilicon demand was above supply due to a surge in project installations in Spain, resulting in the spot price rising to US$400/kg in 1Q08 from US$120/kg in 3Q07. Demand from Spain dried up by the end of 2008 due to policy uncertainty. Coupled with the uncertain macroeconomic outlook, most companies in the supply chain adjusted their inventory. The polysilicon spot price dropped by 80% between 4Q08 and 2Q09 and stabilised thereafter. Module prices fell by about 40% over the same period. Profit margins declined sharply in the supply chain in 2009 due to lower prices and inventory write-downs. Diversification of end markets in 2009 due to financial stimuli. As Continental Europe (79% of 2008 global demand) was less affected by the 2008 financial crisis, demand from key markets, except for Spain, remained strong in 2009. Falling product prices resulted in high project IRRs for solar farms in Germany and demand from that country for 2009 rose by 105% YoY. China was a small market in 2008 (1% of the global market by annual installation), but its size quadrupled in 2009 due to the countrys financial stimulus package. Market-share gains by China companies. The sharp drop in product prices prompted many module makers in Europe to outsource production to Asia (mainly China and Taiwan) in 2009. China module makers accounted for 37% of the global market in 2009, compared with 31% for 2008. In 2009, we also saw Asia polysilicon makers such as GCL Poly and OCI ramp up their output. There was no major industry consolidation in the downturn, as the period of uncertainty lasted only for two quarters and most leading wafer/module makers turned profitable by 2Q09.
Cells (LHS)
Source: Companies, PV Insights
Modules (LHS)
Poly-Si (RHS)
Solar index vs. other energy indices (2008-11)

160 140 120 100 80 60 40 20 0
Jul-08
Mar-08
Nov-08
Mar-09
Jul-09
Aug-10
Nov-09
Dec-10
Apr-10
Nasdaq Global Energy Index

Source: Bloomberg, Daiwa
PHILA Semiconductor Index Solar Index
Where are we now?

Industry is in a price-discovery phase
As a result of almost excess capacity of almost 40%, weak demand visibility in Europe, and rising inventory levels, product prices fell rapidly in 2H11. We expect this to continue until system prices become compelling enough for users to install them without government subsidies. We believe modules priced at below US$1.0/W (system price of US$2.0/W) will change the economics of the solar industry fundamentally, and that annual demand would have to reach 40GW (18GW for 2010) to provide relief from the secular overcapacity situation. Ingot and wafer makers saw the greatest falls in grossprofit margins in 3Q11 and recorded large losses due to ASP pressure and inventory write-offs. Cell-module makers had to increase provisions at the operating level for bad debt (mainly from Europe). We expect ROICs for the solar industry to bottom out in 2H12. - 73 -
Apr-11

3 January 2012

China to become the second-largest market
In 2008, the solar industry in China was fully dependent on the export market, but we expect the domestic market to account for nearly half of demand in 2012. We forecast China demand to increase at a 207% CAGR over 2008-12, from 2008s 45MW of annual installation to 4GW for 2012, and expect the country to become the worlds second-largest PV market in 2012, behind Germany. China aims to install 15GW of capacity by 2015 and 50GW by 2020. Nationwide feed-in tariffs in 2012 will be Rmb1.00/KWh, except in Tibet (Rmb1.15/KWh). There is also a 50-70% capital subsidy under the Golden Sun project. 2H12 should see improving industry fundamentals. We do not expect any meaningful demand impact on solar-cell and module makers in China from the anti-dumping probe led by the US Department of Commerce. However, industry-wide excess capacity and pricing pressure should continue to put pressure on profit margins in 1H12. In addition, we expect normalised profit margins for China projects to be lower than those for projects in Europe and the US due to fierce domestic competition. Rapid solar product-price declines are likely to foster retail-grid parity in many developed economies by mid2012. By then, the main demand driver should be the availability of project finance rather than government subsidies. We also expect gross-profit margin recoveries for both the upstream and downstream players in 2H12.
We also expect a few niche players to survive this consolidation phase.
We expect GCL Poly to be barely profitable in early 2012. However, the company should start to benefit onwards of 2H12 given market-share gains and price stability in solar-product prices. Comtec Solar should survive, because of its exposure to niche n-type mono wafer production. However, we expect the companys long-term revenue growth to be muted. Trina Solar should gain market share on the back of its low cost structure and slightly better financial health. Meanwhile, Yingli is likely to maintain its market share despite having a stronger product portfolio and high exposure to China, due to its weak financial health, and we expect Suntech Power to lose market share due to its weak financial health and mediocre cost structure.
Thematic pick: GCL Poly

A beneficiary of consolidation. We expect major consolidation to take place in the solar industry in 2012. Given that it has the lowest cost structure and largest scale in the industry worldwide, GCL Poly should gain market share rapidly against the backdrop of price declines, while some of its competitors may have to exit the industry. GCL Polys plan has been to increase its polysilicon capacity to 65,000tpa by the end of 2011 and its wafer capacity to ramp up to 10GW by the end of 1Q12 from 6.5GW at the end of 3Q11. The incremental capex from wafer expansion should be minimal due to the use of diamond wire, and we expect the companys polysilicon production cost to reach US$19.0/kg by the end of 2011 and fall by a further 10% YoY for 2012. Its new quasimono wafer production costs are already at the level of its multi-wafer processing costs. As we see polysilicon inventory and hence price pressure continuing to rise in early 2012, we expect the polysilicon price to bottom out in 1Q12 at US$20/kg, ie, the cash cost of the tier-one polysilicon makers. We expect GCL Polys downward earnings adjustment cycle to end by then.
A few large and powerful companies are likely to emerge in China

In 2008 and 2009, the solar industry in China was fragmented due to production outsourcing. More new companies joined the industry. By contrast, it has been in a consolidation phase since late 2011. We expect the majority of small solar companies in the mainstream product space to disappear in 2012. Small polysilicon makers have to shut down their production by the end of 2011 under NDRC directives. Large, offshore, cash-rich companies from Korea and Taiwan have begun acquiring China production bases, and this is likely to continue in 2012. Large, financially-weak solar companies in China may receive government support and undergo massive restructuring, leaving only a few large solar companies. Solar companies that are financially strong and low-cost producers in China would become more powerful in this consolidation process.

We have a Buy (1) rating on GCL Poly and a six-month target price of HK$3.10, based on a PBR of 2.2x on our 2011 BVPS forecast, and representing the average PBR of its trading range over the past two years. We see the
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3 January 2012
key potential share-price catalysts as: 1) a stable polysilicon price, 2) the resolution of the debt crisis in Europe, and 3) high-cost producers potentially leaving industry in 1H12. The downside risks to our Neutral
Solar: target prices
Company GCL Poly Yingli Solar
rating on the sector include a prolonged period of industry oversupply, funding risks for GCL Poly, and any breakthrough in thin-film technology.
Bloomberg code 3800 HK YGE US
Share price Six-month Upside/downside 19-Dec-11 target price potential 2012E PER (local curr.) (local curr.) (%) (x) Valuation basis 2.08 3.10 49.0 9.6 A 2.2x PBR on our 2011E BVPS, which translates into an EV/EBITDA multiple of 7x for 2012 3.25 3.25 (8.2) n.a. A 0.3x PBR on our 2011E BVPS, implying 0.55x on our 2012E adjusted NTA
Solar: valuation summary

Company GCL Poly Yingli Solar Bloomberg code 3800 HK YGE US Share price 19-Dec-11 (local curr.) Rating 2.08 Buy 3.25 Underperform Six-month target price (local curr.) 3.10 3.25 +/- Year (%) end 49.0 Dec (8.2) Dec PER (x) 2010 2011E 2012E 2013E 8.0 2.5 6.2 8.7 9.6 n.a 6.3 5.3 EV/EBITDA (x) 2010 2011E 2012E 2013E Dividend yield (%) 2010 2011E 2012E 2013E 1.8 n.a 1.8 n.a 1.8 n.a 1.8 n.a
5.4 2.3
4.7 6.2
5.4 8.0
4.1 5.4
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3 January 2012
production and consumption to turn negative YoY during 1Q12 and for most of 2Q12 because of the lag impact of monetary loosening and the high base for the previous-year periods.
Steel Neutral
Alexander Latzer (852) 2848 4463 (alexander.latzer@hk.daiwacm.com)
China steel companies*: net profit and EBIT margin

(Rmb m) 6,000 4,500 3,000 1,500 0 (1,500) (3,000) 1H06 2H06 1H07 2H07 1H08 2H08 1H09 2H09 1H10 2H10 1H11A 2H11E 1H12E 2H12E 1H13E 2H13E 1H14E 2H14E 20% 15% 10% 5% 0% (5%) (10%)

The slowdown in steel production during the global financial crisis was V-shaped (25% fall from peak to trough in five months and a 49% recovery in nine months). China steel-company profits recovered in 2H09 post the global financial crisis due to the positive impact of fiscal stimulus on demand. But input costs (mainly iron ore) began to rise strongly and pricing power was lacking to pass on the costs fully. Profits quickly eroded and have been on a downward trend ever since. Input costs continue to move with steel prices and, as a result, the recent fall in the former has not materially improved steel-company profitability.
Net profit (LHS)
EBIT margin (RHS)
Source: Companies, Daiwa forecasts Note: *Figures are the average of Angang, Baosteel and Maanshan
Where are we now?

We see the current environment as much more challenging for China steel producers than that during the global financial crisis. The current slowdown may not be as deep or as sudden as during the 2008 crisis (down 18% peak to trough over nine months), but the outlook for a recovery in profitability to pre-global financial crisis levels is highly unlikely (see graphs this page). We forecast steel consumption to increase by only 1.3% YoY for 2012, which is below the trough of 2.0% YoY for 2008. In addition, we forecast China steel
We expect the slowdown in steel production to be less sudden ahead compared with during the global financial crisis, but the recovery to be more slow. Steel is a good example of the problems facing Chinas industry over the next few years. It is high-volume and low-value, and energy- and raw-material intensive. We forecast China steel production and capacity growth to slow during the next few years, reflecting the low returns and the governments push to consolidate the sector. We continue to see the sector as one to trade, not hold long term, because of endemic overcapacity and low returns on capital. The 12th Five-Year Plan for the steel industry emphasises consolidation and a move to higher-value production. The closure of obsolete capacity has been slow (about 1-2% a year) and it is likely that low-value steel exports will rise ahead.
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3 January 2012
China crude-steel production

(m tonnes) 75 70 65 60 55 50 45 40 35 30 25 20 (Est.) GFC Peak to Trough: -25% from June to Nov., 2008 GFC Trough to Peak: +49% from Nov., 2008 to Aug., 2009 Peak to Trough: -18% from May, 2011 to Feb., 2012E Trough to Peak: +35%? 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% (10%) (20%)
Jul-06
Jul-07
Jul-08
Jul-09
Jul-10
Jul-11
Oct-06
Oct-07
Oct-08
Oct-09
Oct-10
Oct-11
Jul-12
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Monthly crude production (LHS)

Source: Custeel, Daiwa forecasts
YoY growth (RHS)
Steel capacity was being rapidly added in China prior to the global financial crisis, which resulted in a declining operating rate at that time (see graph below). China steel companies assumed that demand growth would remain robust and profitability maintained due to strong pricing power (input cost pass-through). With little capacity growth ex-China, Chinas share of global steel production increased from about 30% to 50% during the global financial crisis and is now about 45%.
Pricing power has largely vanished for the global steel industry, in particular in China, where steel prices have lagged global steel prices. Most steel companies exChina are still running their plants at low operating rates of about 72-77% compared with the high 80 levels prior to the global financial crisis and a low of 60-65% during the crisis. Post the global financial crisis, we do not anticipate China steel-company operating rates rising to their previous highs for a few years due to slowing demand growth and a slowdown in infrastructure spending by the end of the 12th Five-Year Plan.
China crude steel production: capacity, and operating rates*

(m tonnes) 1,000 900 800 700 600 500 400 300 200 100 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E Steel production (LHS)
Source: Custeel, China Customs, Daiwa forecasts Note: *Capacity is average annual figure
Oct-12
Apr-06
Apr-08
Apr-10
Apr-11
Apr-07
Apr-09
Apr-12
107% 100% 92% 94% 103% 96% 93% 100% 94% 91% 85% 82% 87% 79% 89% 87% 86% 87% 89% 96% 93% 89% 86% 82% 79% 75% 72% Steel capacity (LHS) Utilisation rate (RHS)
The fragmented nature of the steel supply chain (producer and distributor) also contributes to weak pricing power, as producers receive information on shifts in demand too late. As a rough guide, steel producers on average supply about half of their steel directly to the customer base, while the other half is distributed through traders and other intermediaries.
This is both a feature of Chinas industry (intermediaries capturing a disproportionate amount of value and raising costs), as well as a function of the low value orientation of the market.
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3 January 2012
The China steel industry remains highly dependent on the construction sector (about 55-60% of steel consumption). While this is natural given the stage of development of the China steel industry, we believe it is nearing the point of being unsustainable due to the rapid investment programme of the past few years. Our forecasts for the period from 2015-20 call for construction steel, such as long products, to fall to about 40% of steel consumption and the auto/appliance/energy/machinery sectors to increase their shares.
China steel consumption by end-use sector*

Construction Commercial Residential Infrastructure, other Machinery Automobile Home Appliance Container Shipbuilding Railway Pipeline Elec. power Others Total 2011E YoY chg. (%) 351.0 9.0 113.0 11.9 6.9 128.1 109.9 8.9 8.0 111.8 51.8 8.0 8.0 9.7 5.1 8.0 19.0 8.0 6.9 9.0 5.0 6.9 20.2 8.0 40.2 2.0 8.1 622.3 2012E Share of total (%) YoY chg. (%) 351.0 55.7 0.0 108.5 17.2 (4.0) 127.4 20.2 (0.5) 115.1 18.3 4.8 115.2 18.3 3.0 53.2 8.4 2.8 10.0 1.6 2.8 5.1 0.8 1.6 19.3 3.1 2.0 7.2 1.1 5.0 7.2 1.1 5.0 21.0 3.3 4.0 41.0 6.5 2.0 630.2 100.0 1.3
Steel consumption should contract YoY in 1H12

Our forecast recovery in steel production and consumption appears aggressive (see graph at bottom of previous page), but anything less would result in zero or negative YoY growth for both. We see the downside risk to our consumption-growth forecast of 1.3% YoY as being as low as negative 5.0% YoY. Negative YoY growth could occur if construction consumption is not 0% YoY as we forecast, but negative YoY, and the growth rates of the other sectors are not sufficient to offset this. As mentioned, YoY growth for 1Q12 and 2Q12 should be negative, with our forecast calling for a low of -13.7% YoY in January 2012 to -1.3% YoY for July 2012. We forecast 0% YoY growth in steel consumption from the construction sector (see following below). This is due to the adverse impact during 1H12 of tight credit conditions on commercial and residential construction, partially offset by increases in infrastructure. Residential consumption growth would be even more negative, in our opinion, were it not for the positive growth in the social housing component, which is about half of the residential share of the total. Currently, three sectors appear to have the brightest prospects for 2012: heavy equipment, energy and automobiles. The biggest risk to our forecasts is construction, both to the upside and downside, depending on how rapidly monetary easing occurs over the next few months. But we see little changing the outlook for consumption growth during 1Q12, which will be deeply negative in our opinion. Daiwas economics team sees monthly loan growth of over Rmb600bn as positive and forecasts four more RRR cuts, one a month from January to April. Daiwa forecasts nominal FAI for 2012 to be about 16.5% YoY, down from 24% YoY for 2011.
Source: CMIPRI, CBI, Daiwa forecasts. Note:* Figures are preliminary, representing the apparent consumption of finished steel

We believe the China steel companies profit margins are nearing a trough, with losses for 4Q11 and 1Q12. However, we do not forecast an improvement to the levels prior to the global financial crisis, due to a loss of pricing power, slowing steel demand domestically and overseas, high input costs, and regulatory cost increases, including lower export rebates. We see the recent fall in iron-ore prices as a mixed blessing, helping to ease our forecast downturn in profitability near term, but potentially forestalling the need for industry restructuring. Iron-ore prices need to fall on a sustained basis relative to steel prices in order to reverse the profit-margin erosion of the past few years. Given the outlook for sector growth and profitability, there is little reason to expect valuations will return to their previous average levels of about 50% above book value. We think the China steel industry has reached the point where consolidation is the only way forward. The industry needs tight credit conditions and slowing infrastructure spending to begin the transformation to lower-volume, higher-value, and lower-energy and raw-material-intensive orientation from the opposite today. We expect industry profitability to improve but remain below the pre- global financial crisis levels. We forecast EBIT margins of 5-10% for 2012 compared with 10-15% prior to the crisis.
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3 January 2012
Thematic pick: Baoshan Iron and Steel

Baoshan Iron and Steel (Baosteel) was specifically mentioned in the 12th five-year steel-industry plan as being designated to lead the transformation of the industry through growth in higher-value steel and consolidation. The company has the leading market share in higher-value auto and appliance steel applications, and is well-suited to help drive the initiative over the next five years. The stock is also inexpensive, trading in line with its historical low PBRs (see following chart) and slightly below that during the global financial crisis. The share price has lagged the increase in the Hong Kong-listed steel stocks since late September 2011, yet offers more relative value and higher returns than its China steel-sector peers, based on our forecasts. Upside share-price catalysts include higher steel prices and a bottoming out of steel-industry demand, which we foresee during 1Q12.
Baosteel PBR bands and share price
Price Rmb 21 18 15 12 9 6 3 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Companies, Bloomberg, Daiwa forecasts
Global steel industry ROE (China steel companies* in grey)

Severstal (Russia) JSW Steel Jindal Steel & Power Hyundai Hysco Evraz (Luxembourg) Godawari Bhushan Steel Tata Steel AK Steel Allengheny Technology Steel Dynamics Nucor Hyundai Steel Steel Authority Posco Wuhan Sumitomo Metal Industries China Steel Thyssen Krupp (Germany) Baosteel Dongkuk Steel Onesteel U.S. Steel JFE Holding Arcelor Mittal Kobe Steel Shougang Bluescope Steel Maanshan Nippon Angang 0 3.7 2.9 2.7 5 10 15 20 25 30 3.9 6.0 5.4 4.9 6.4 9.7 8.9 8.9 8.6 8.6 8.0 7.5 10.0 11.0 14.0 13.9 13.8 13.2 13.1 13.0 11.8 14.6 16.2 19.0 17.6 24.4 23.3 23.3
Source: *Based on Bloomberg-consensus forecasts for 2012
2.9x Avg+2SD 2.2x Avg+1SD 1.5x Avg 0.8x Avg-1SD
Steel: target prices

Company Baosteel Angang
Bloomberg code 600019 CH 347 HK
Share price Six-month Upside/downside 19-Dec-11 target price potential 2012E PER (local curr.) (local curr.) (%) (x) Valuation basis 21.0 27.3 DCF and one-year forward PBR 4.71 5.70 5.41 4.75 12.2 98.1 DCF and one-year forward PBR
Steel: valuation summary

Company Baosteel Angang Bloomberg code 600019 CH 347 HK Share price 19-Dec-11 (local curr.) 4.71 5.41 Rating Outperform Outperform Six-month target price (local curr.) 5.70 4.75 +/- Year (%) end 21.0 Dec 12.2 Dec PER (x) 2010 2011E 2012E 2013E 6.4 10.7 27.3 8.9 16.5 n.a. 98.1 13.4 EV/EBITDA (x) 2010 2011E 2012E 2013E 4.4 5.2 6.7 4.3 6.1 7.6 6.6 4.8 Dividend yield (%) 2010 2011E 2012E 2013E 7.0 4.2 1.6 5.1 3.3 0.4 0.5 3.7
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3 January 2012
ARPU from Rmb83 in 2008 to Rmb73 in 2010, while the EBITDA margin began to drop below the 50% level for the first time in 2010.
Telecommunications Neutral
Alan Kam, CFA (852) 2848 4978 (alan.kam@hk.daiwacm.com) Alicia Hu (852) 2532 4180 (alicia.hu@hk.daiwacm.com)
Overall subs net add market share in China

140% 120% 100% 80% 60% 40% 20% 0% -20% -40% 2006 2007 2008 2009 CM
2010 CU CT
2011E
2012E
2013E

Restructuring impaired the defensiveness of the telecos in the previous bear market
In our view, industry restructuring in late 2008 was a specific situation that impaired the defensive nature of the telecoms operators during 2008-09. We believe the start-up costs of 3G services together with the reshuffling of fixed and mobile assets between operators, rather than the bad economy, weighed on operators earnings in 2008-09.
Earnings for telecoms operators amid restructuring
(Rmb m) 150,000 145,000 140,000 135,000 130,000 125,000 120,000 115,000 2007 2008 Total earnings (LHS) 2009 Growth (RHS) 50% 40% 30% 20% 10% 0% (10%)
Meanwhile, CTs earnings decline for 2008-09 was strategically-driven, as CT needed to expand the subscriber use base of its newly acquired CDMA business to reach critical mass through aggressive handset subsidies, sacrificing its short-term profitability. Stripping out the gain on the disposal of its CDMA business, CU reported a sharp decline in earnings for 2008-10 due to heavy investment in 3G (both capex and start-up expenses), as CU is the only operator to finance 3G capex at the listed-company level.
Where are we now?

China is entering the next phase of 3G development with over 100m 3G users
Telecoms services were regarded as a luxury in China about 10 years ago, but have now become a daily necessity for consumers, with the mobile-penetration rate reaching 72% in November 2011. In our view, data services will follow to become the next daily necessity based on how we have seen smartphones change users data usage in the developed markets. Mobile users in Hong Kong are at the forefront of the global smartphone usage, with about a 50% penetration currently. Data traffic in Hong Kong surged to 418MB per month per user in September 2011 from 38Mb in 2008, when smartphones began to gain traction in the market. We expect to see a similar data growth pattern in China, but do not expect the data usage to rise to such a high level given that all the data packages in China are metered plans, unlike Hong Kong, where most smartphone users subscribe to unlimited data plans.
Source: Companies, Daiwa calculations Note: Earnings for 2008 include one-off gains on the disposal of CDMA at Rmb26bn
Industry restructuring has changed the competitive landscape in China, bringing China Telecom (CT) into the mobile market with its CDMA network, which was transferred from China Unicom (CU) in January 2009. The overall subscriber net adds split between China Mobile (CM) and CU changed from 80/20 in 2006-07 to a 45/30/25 split among CM, CU and CT, respectively, in November 2011. CMs earnings growth slowed from 29% YoY for 2008 to 2-4% YoY for 2009-10 due to the intensifying competition as evidenced by the decline in its blended
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3 January 2012
Nevertheless, we believe data traffic in China will grow, supported by the promotion of low-end smartphones and increase in smartphone applications, such as instant messengers with SNS and voice features. Historical data indicates that telecoms revenue has a weak correlation with GDP growth. We believe mobile penetration, price competition and regulatory intervention have played more important roles in industry revenue growth. The growth of telecoms revenue has decelerated and fallen below GDP growth since telecoms restructuring in late 2008. Nevertheless, the growth in the 3G subscriber base together with the rise in data traffic have helped revive telecoms revenue growth, with revenue forecast to rise by 10-13% YoY for 2011, based on our forecasts.
China: telecoms revenue and GDP growth (2003-10)
20% 15% 10% 5% 0% Telecom restructuring started in late 2008
mobile competition remains intense, with mobile penetration reaching a high level (over 70% currently), while operators continue to focus on the promotion of low-end smartphones and 3G net adds as evidenced by the margin squeeze seen in their recent 3Q11 results.
Earnings for telecoms operators in China
(Rmb m) 180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 2009 2010 2011E 2012E 2013E Total earnings (LHS)
20% 15% 10% 5% 0% (5%) (10%) Growth (RHS)
Thematic pick: China Telecom

CT is our top pick in the China Telecoms Sector. We like the company for its good earnings visibility, better execution and cost control. In 3Q11, CT was able to add a total of 6.9m 3G users at the expense of a 1.9pp QoQ EBITDA margin contraction, where CUs EBITDA margin declined by 2.7pp QoQ, with only 6.3m net adds in the same period. Meanwhile, CT has successfully transformed itself into an integrated-service provider. The effective bundling strategy enabled CT to expand its mobile user base threefold from 29m in 3Q08, when it acquired the CDMA network from CU, to 117m in 3Q11, of which 3G subscribers account for 24% of the total. CTs broadband users reached 74m in 3Q11. CT indicated that more than 50% of its mobile and broadband users are now bundled. In our view, CT is well positioned to capture the growth in data traffic we expect in 2011-12.
Nov-03
Nov-04
Nov-05
Nov-06
Nov-07
Nov-08
May-04
May-05
May-06
May-07
May-08
May-09
Nov-09
Telecom revenue growth (%)

Source: National Bureau of Statistics, MIIT
GDP growth (%)

Regaining defensiveness along with 3G development in 2011-12
In our view, the China Telecoms Sector is unlikely to see earnings decline as it did in 2008-09, as a result of strong 3G subscriber base growth together with rising data traffic. We note that the growth in telecoms revenue has recovered from the bottom in early 2009 and surpassed GDP growth since October 2010. Monthly telecoms revenue has registered 10-15% YTD growth. We expect an earnings recovery in 2011-12, with industry earnings rising by 5-8% YoY for 2011-12 (we forecast operators earnings to rise by 3-14% YoY for 2011 and 3-12% YoY for 2012, excluding the earnings rebound for CU). Nevertheless, we believe the sector has not fully regained its past defensiveness, given that
May-10

Our DCF-based six-month target price of HK$5.22 implies a target 2011E PER of 20x. We believe the potential launch of the CDMA version of the iPhone 4S in 1Q12 could help CT take high-end users away from CM.
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3 January 2012
Telecommunications: target prices

Company China Telecom China Mobile China Unicom
Share price Six-month Upside/downside 19-Dec-11 target price potential 2012E PER (local curr.) (local curr.) (%) (x) Valuation basis 4.5 5.2 17 15.2 DCF 73.3 77.8 6 9.4 10x 2012 PER 15.7 15.9 1 26.7 DCF
Telecommunications: valuation summary

Company China Telecom China Mobile China Unicom Bloomberg code 728 HK 941 HK 762 HK Share price 19-Dec-11 (local curr.) 4.5 73.3 15.7 Rating Outperform Hold Hold Six-month target price +/- Year (local curr.) (%) end 5.2 17 Dec 77.8 6 Dec 15.9 1 Dec 2010 19.8 10.1 81.8 PER (x) 2011E 2012E 2013E 17.0 15.2 12.8 9.7 9.4 9.2 55.9 26.7 20.8 2010 4.3 4.0 6.3 EV/EBITDA (x) 2011E 2012E 2013E 4.0 3.5 3.1 3.4 3.0 2.7 5.6 4.7 4.1 2010 2.0 4.2 0.6 Dividend yield (%) 2011E 2012E 2013E 2.0 2.0 2.0 4.4 4.6 4.7 0.9 1.7 2.0
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3 January 2012
Thermal coal prices

(US$/t) 200 150
Thermal Coal Positive

Felix Lam (852) 2532 4341 (felix.lam@hk.daiwacm.com)
100 50 0
Jul-08
Jul-09
Jul-10
Oct-08
Oct-09
Oct-10
Jul-11
0
Jan-09
Jan-10
Jan-08
Jan-11
Apr-08
China (5800kcal)
Australia (6700kal)

Coal demand rose rapidly post stimulus plan
Source: Bloomberg, CCTD
Where are we now?

Same problem, different situation
In 2011, China is facing another financial crisis triggered by the Eurozone debt crisis. To avoid a hardlanding scenario, the government started to relax tightening policies not long ago, but the easing will be smaller and more selective this time round. Generally, the government is committed to reducing the pace of GDP growth. Daiwa forecasts GDP growth to slow to 8.5% YoY for 2011. The rapid rebound in GDP that occurred from 1Q09 to 1Q10 is unlikely to reoccur. The slowdown in GDP growth will also mean that energy demand and coal consumption slow.
China encountered headwinds in its economy domestically and externally from the US. To prevent a hard-landing for the economy (ie, GDP growth falling below 8% YoY), the country launched a stimulus plan in 2008 and started to ease credit tightening for banks. As a result, demand growth for coal rose in 2009-10 to 1213% a year, compared with less than 10% YoY for 2008. Domestic coal prices increased rapidly in 2008 to over Rmb1,000/tonne on average in July (for coal with a heat value of 5,800kcal/kg), up 67% from the beginning of that year. A major driver of this, in our view, was seaborne coal prices, which surged during the period as a result of disruptions to seaborne coal supply (flooding in Australia). Subsequently, spot prices in China retreated by 40% to a trough of about Rmb590/tonne in March 2009, post the 2008 global financial crisis, triggered by the US sub-prime mortgage issues.
Coal prices surged then fell sharply
Coal prices likely to fall over the next few months

While coal prices have increased year-to-date, the pace has been mild. Coal with the same heat value (5,800kal/kg) is now about Rmb885/tonne, up only 7% since the beginning of the year. As a result, even though spot prices for domestic and seaborne coal have softened and are likely to stay on a downtrend in the short term due to weakening demand, we do not expect them to fall as sharply as they did in 2008-09.
China: domestic and international coal prices
(US$/t) 200 150 100 50 0 We do not expect coal prices to surge and fall sharply in 2011-12 as they did in 2008-09 (US$/t) 60 40 20
Share prices dropped sharply despite robust demand outlook

Demand growth for coal remained robust amid the crisis. But this did not translate into good share-price performances for the China coal stocks. While the major reason for this was likely the abnormally high valuations of China Shenhua Energy (Shenhua) and China Coal Energy (China Coal) (PERs of over 30x), Yanzhou Coal had no volume and capacity growth over the period. Together with the collapse in spot coal prices from unsustainably high coal prices in 2-3Q08, we believe there were solid reasons for the share prices of Shenhua, China Coal and Yanzhou Coal falling by an average of 84% from peak to trough in 2008, much worse than the average of 43% from July to early October this year.
(20) (40) (60)
Jul-08
Jul-09
Jul-10
Apr-08
Apr-09
Apr-10
Oct-08
Oct-09
Oct-10
Apr-11
Jul-11
Jan-08
Jan-09
Jan-10
China (5800kcal)
Source: Bloomberg, CCTD
Australia (6700kal)
- 83 -
Jan-11
Premium(Discount) (RHS)
Oct-11
Oct-11
Apr-10
Apr-11
Apr-09

3 January 2012
Coal transportation remains an issue

China has been a net exporter of coal since 2009. Although the country is self-sufficient in coal, the allocation of the resource has been a challenge. In the first 10 months of 2011, production in the major coalmining provinces Shanxi, Shandong, Shaanxi, Henan, Inner Mongolia, and Guizhou accounted for 63% of the countrys total production. Relying purely on domestic coal supply to meet national demand will create a lot of stress on coal-railway infrastructure, which is already a bottleneck in the coal supply chain.
China: coal production by province (8M11)
Shanxi 19.1%
by coal output in 2010, has also made good progress in consolidation, with over 80% of production going into the hands of key state-owned mines in 2011, compared with 58% in 2008. However, industry consolidation in the country overall appears to have made little progress. Notably, the market shares of key-state owned mines in Inner Mongolia and Shaanxi Provinces, the largest- and third-largest provinces by 2010 coal output, have fallen fairly rapidly, from about 43-44% in 2008 to our estimate of just 35-36% for 2011.
China: raw coal production
2006 Total raw coal production (m tonnes) Shanxi 581 Inner Mongolia 284 Anhui 83 Shandong 138 Henan 183 Guizhou 118 Shaanxi 166 Top seven 1,554 Others 778 China 2,332 Top seven as a % of national 67 2007 632 348 94 137 189 109 175 1,682 842 2,523 67 2008 645 502 116 137 213 113 242 1,969 833 2,802 70 2009 616 601 126 141 196 137 294 2,110 851 2,960 71 2010 741 787 131 149 179 160 361 2,507 906 3,413 73
Others 37.1%
Anhui 3.6% Shandong 4.1% Guizhou 4.2% Henan 5.1%
Inner Mongolia 18.8%
Shaanxi 8.0%
Source: CCTD
China: quarterly coal trades

(Tonnes m) 60 50 40 30 20 10 0 (10) (20)
Production from key-state owned mines (m tonnes) Shanxi 301 326 Inner Mongolia 147 177 Anhui 57 67 Shandong 97 95 Henan 85 97 Guizhou 20 21 Shaanxi 89 99 Top seven 795 882 Others 326 347 China 1,122 1,229 Production from key-state owned mines as a % of total Shanxi 52 52 Inner Mongolia 52 51 Anhui 68 71 Shandong 70 70 Henan 46 51 Guizhou 17 20 Shaanxi 54 57 Top seven 51 52 Others 42 41 China 48 49
Source: SXCoal
353 215 87 94 123 23 105 999 378 1,377
379 284 94 94 129 26 130 1,136 382 1,518
523 283 97 101 142 28 126 1,300 394 1,694
Import
Source: CCTD
Export
Net import
Consolidation is expanding from Shanxi to other provinces

Based on the data we have, consolidation was still at an early stage in 2008 for Shanxi Province, the second largest coal production base now for China (currently accounting for about 21% of national production). Following the closure of small mines and their consolidation by large state-owned mining companies, coal output in the province has now become less fragmented. For 2011, we estimate key state-owned mines accounted for 71% of total output in Shanxi, compared with 55% in 2008. Henan, the fourth-largest province
55 43 75 68 58 20 44 51 45 49
62 47 75 67 66 19 44 54 45 51
71 36 74 68 80 17 35 52 44 50
1Q07
2Q07
3Q07
4Q07
1Q08
2Q08
3Q08
4Q08
1Q09
2Q09
3Q09
4Q09
1Q10
2Q10
3Q10
4Q10
1Q11
2Q11
3Q11
Near-term challenge: price control
The NDRC plans to control thermal coal prices, and implement measures to prevent local governments from putting cost pressure on coal-mining companies. We see execution risks associated with the price controls, as many traders and distributors are involved in coal sales between the coal miners and IPPs. That said, we expect the three coal companies we cover to follow the NDRCs pricing guidance, although they could try to sell more coal on the spot market and/or sell less to IPPs to alleviate the impact on their earnings. - 84 -

3 January 2012

Total demand growth should slow
Coal-fired power plants, steel mills, and cement producers are the three major consumers of coal, accounting for respectively 46%, 17% and 12% of Chinas total consumption for 2010. For the first nine months of 2011, the output growth of electricity, cement, and steel were all below the growth levels for the same period in 2010. We forecast total coaldemand growth to slow from 13% YoY for 2010 and 9.7% for 2011 to 7.8% in 2012, on the back of a slowdown in GDP and FAI growth.
China: coal-demand forecasts
(tonnes m) 4,200 3,500 2,800 2,100 1,400 700 0 2006 2007 2008 2009 2010 2011E 2012E 2013E Coal demand (LHS)
Thematic pick: China Shenhua Energy

Shenhua remains our top pick in the China Coal Sector. Its integrated business model (from mining to logistics to power supply) increases its earnings visibility, which is valuable given the present market volatility and the uncertain macroeconomic outlook. We forecast an EPS CAGR of 14% for 2011-13 for the company. We expect high spot prices and sales volume for coal, and a gradual increase in power generation to underpin this. Its gross-profit margin should come down over the same period on higher coal-production costs and an increased revenue contribution from the coal trading business, which has thinner profit margins.
Shenhua: earnings and sales volume growth
(Rmb bn) 60 50 40 30 20 10 0 2005 2006 2007 2008 2009 2010 2011E 2012E Adj net income (LHS)
Source: Company, Daiwa forecasts
(%) 14 12 10 8 6 4 2 0 YoY growth (RHS)
(tonnes m) 500 400 300 200 100 0 Sales volume (RHS)
Coal prices likely to soften in the early part of 2012 before firming up
Weakened coal demand globally has resulted in a 10% decline in spot prices for thermal coal from Newcastle Australia (6,700kcal/kg), to US$111/tonne since September, while the prices for coal from Richards Bay, South Africa, have fallen even more. In China, demand is softening due to the slowing economy, and spot coal prices have edged down in December. We expect coal prices to stay on the downtrend in 1Q12. Therefore, there could be downside risk to Daiwas forecast of a seaborne spot price of US$130/tonne for 2012.
Our target price implies a 22% return over the next six months
The stock is trading currently at PERs of 11.2x and 9.9x for 2011E and 2012E, respectively, lower than its average one-year-forward PER of 15.6x since 2006. Our DCF-based target price of HK$39.70 assumes a WACC of 10.6%, and implies 22% upside potential.
Consolidation to expand to Inner Mongolia and other provinces

As mentioned, consolidation has been progressing well in Shanxi and Henan Provinces, with the market shares of key state-owned mines having increased rapidly over the past three years. The industry in the other major coal-producing provinces, however, has become more fragmented. We expect the government to promote consolidation in these provinces as well. This would be positive for the longer-term supply outlook for coal in China, in our opinion.
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3 January 2012
Shenhua: share price and one-year-forward PER

(HK$) 70 60 50 40 30 20 10 0 Avg 15.6x Over 30x PER (x) 30 25 20 15 10 5 0
A sharp deterioration in seaborne coal prices Imported coal prices are trading at a discount to domestic coal prices. In our view, there is a risk that seaborne prices will fall further should the global economic environment deteriorate and at a faster pace. A widening of the discount between domestic and import prices would lead to more imports, in our view, at the expense of domestic coal. As a result, spot prices for coal in China would be dragged down. The coal companies earnings will be increasingly sensitive to spot prices, as they are selling more coal on the spot market now than in the past. Delays in coal mine expansions We have factored into our forecasts the start of operations at new coal mines, as well as the expansion of existing mines in China (and overseas for Yanzhou Coal). We expect these projects to come on stream gradually beyond 2013. Significant delays in rolling out most of these projects would affect our DCF valuations.
Risks and catalysts

While we regard asset injections by the parent companies as positive share-price catalysts, we see the following as the major risks for the sector and the companies.
Thermal Coal: target prices
Company Yanzhou Coal Mining China Shenhua Energy China Coal Energy
Thermal Coal: valuation summary

Company Bloomberg code Yanzhou Coal Mining 1171 HK China Shenhua Energy 1088 HK China Coal Energy 1898 HK
Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11
Share price 1-year forward PER (RHS)
Share price Six-month Upside/downside 19-Dec-11 target price potential 2012E PER (HK$) (HK$) (%) (x) Valuation basis 15.70 22.6 43.9 6.6 DCF with a WACC of 12.3% 32.60 39.7 21.8 9.9 DCF with a WACC of 10.6% 8.45 10.0 18.3 8.5 DCF with a WACC of 11.4%
Share price 19-Dec-11 (HK$) 15.70 32.60 8.45
Rating Buy Buy Hold
Six-month target price +/- Year (HK$) (%) end 22.6 43.9 Dec 39.7 21.8 Dec 10.0 18.3 Dec
2010 8.9 14.6 13.0
PER (x) 2011E 2012E 2013E 7.2 6.6 6.2 11.2 9.9 8.9 9.4 8.5 7.4
2010 5.0 7.8 5.9
EV/EBITDA (x) 2011E 2012E 2013E 5.2 4.4 3.8 6.2 5.2 4.4 6.0 5.5 4.7
2010 4.6 2.8 2.2
Dividend yield (%) 2011E 2012E 2013E 4.0 4.6 4.8 2.9 4.0 5.1 3.2 3.5 4.7
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3 January 2012
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3 January 2012
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3 January 2012
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3 January 2012
Daiwas Asia Pacific Research Directory

Hong Kong Regional Research Head Regional Research Co-head Head of Product Management Head of Thematic Research; Product Management Head of China Research, Chief Economist (Regional) Macro Economics (Regional) Regional Chief Strategist; Strategy (Regional) Head of Hong Kong Research; Regional Property Coordinator; Co-head of Hong Kong and China Property; Property Developers (Hong Kong) Automobiles and Components (China) Head of Greater China FIG; Banking (Hong Kong, China) Banking (Hong Kong, China) Insurance Capital Goods Electronics Equipments and Machinery (Hong Kong, China) Consumer, Pharmaceuticals and Healthcare (China) Conglomerate (Hong Kong, China) Consumer/Retail (Hong Kong, China) Head of HK and China Gaming and Leisure; Hotels, Restaurants and Leisure Casinos and Gaming (Hong Kong); Capital Goods Conglomerate (Hong Kong) Internet (Hong Kong, China) Regional Head of IT/Electronics; Semiconductor/IC Design (Regional) IT/Electronics - Semiconductor/IC Design (Taiwan) Regional Head of Materials; Materials/Energy (Regional) Materials (China) Head of Hong Kong and China Property; Property Developers (Hong Kong, China) Property (Hong Kong, China) Regional Head of Small/Medium Cap; Small/Medium Cap (Regional) Small/Medium Cap (Regional) Head of Solar Telecommunications (Greater China) Transportation Aviation, Land and Transportation Infrastructure (Regional) Transportation Transportation Infrastructure; Capital Goods Construction and Engineering (China) Regional Head of Clean Energy and Utilities; Utilities; Power Equipment; Renewables (Hong Kong, China) Head of Custom Products Group; Custom Products Group Custom Products Group Custom Products Group Custom Products Group Nagahisa MIYABE Christopher LOBELLO John HETHERINGTON Tathagata Guha ROY Mingchun SUN Kevin LAI Colin BRADBURY Jonas KAN Jeff CHUNG Grace WU Queenie POON Jennifer LAW Joseph HO Hongxia ZHU Peter CHU Matthew MARSDEN Gavin HO Alicia HU Eric CHEN Ashley CHUNG Alexander LATZER Felix LAM Danny BAO Yannis KUO Mark CHANG John CHOI Pranab Kumar SARMAH Alan KAM Kelvin LAU Edwin LEE Dave DAI Justin LAU Philip LO Jibo MA Kenji SERIZAWA (852) 2848 4971 (852) 2848 4916 (852) 2773 8787 (852) 2773 8731 (852) 2773 8751 (852) 2848 4926 (852) 2848 4983 (852) 2848 4439 (852) 2773 8783 (852) 2532 4383 (852) 2532 4381 (852) 2773 8745 (852) 2848 4443 (852) 2848 4460 (852) 2848 4430 (852) 2848 4963 (852) 2532 4384 (852) 2532 4180 (852) 2773 8702 (852) 2848 4431 (852) 2848 4463 (852) 2532 4341 (852) 2773 8715 (852) 2773 8735 (852) 2773 8729 (852) 2773 8730 (852) 2848 4441 (852) 2848 4978 (852) 2848 4467 (852) 2532 4349 (852) 2848 4068 (852) 2773 8741 (852) 2773 8714 (852) 2848 4489 (852) 2532 4159 nagahisa.miyabe@hk.daiwacm.com christopher.lobello@hk.daiwacm.com john.hetherington@hk.daiwacm.com tathagata.guharoy@hk.daiwacm.com mingchun.sun@hk.daiwacm.com kevin.lai@hk.daiwacm.com colin.bradbury@hk.daiwacm.com jonas.kan@hk.daiwacm.com jeff.chung@hk.daiwacm.com grace.wu@hk.daiwacm.com queenie.poon@hk.daiwacm.com jennifer.law@hk.daiwacm.com joseph.ho@hk.daiwacm.com hongxia.zhu@hk.daiwacm.com peter.chu@hk.daiwacm.com matthew.marsden@hk.daiwacm.com gavin.ho@hk.daiwacm.com alicia.hu@hk.daiwacm.com eric.chen@hk.daiwacm.com ashley.chung@hk.daiwacm.com alexander.latzer@hk.daiwacm.com felix.lam@hk.daiwacm.com danny.bao@hk.daiwacm.com yannis.kuo@hk.daiwacm.com mark.chang@hk.daiwacm.com john.choi@hk.daiwacm.com pranab.sarmah@hk.daiwacm.com alan.kam@hk.daiwacm.com kelvin.lau@hk.daiwacm.com edwin.lee@hk.daiwacm.com dave.dai@hk.daiwacm.com justin.lau@hk.daiwacm.com philip.lo@hk.daiwacm.com jibo.ma@hk.daiwacm.com kenji.serizawa@hk.daiwacm.com
South Korea Head of Research; Strategy; Banking/Finance Regional Head of Automobiles and Components; Automobiles; Shipbuilding; Steel Banking/Finance Capital Goods (Construction and Machinery) Consumer/Retail Insurance IT/Electronics (Tech Hardware and Memory Chips) Materials (Chemicals); Oil and Gas Telecommunications; Software (Internet/Online Games) Custom Products Group Chang H LEE Sung Yop CHUNG Anderson CHA Mike OH Sang Hee PARK Yumi KIM Jae H LEE Jihye CHOI Thomas Y KWON Shannen PARK (82) 2 787 9177 (82) 2 787 9157 (82) 2 787 9185 (82) 2 787 9179 (82) 2 787 9165 (82) 2 787 9838 (82) 2 787 9173 (82) 2 787 9121 (82) 2 787 9181 (82) 2 787 9184 chlee@kr.daiwacm.com sychung@kr.daiwacm.com anderson.cha@kr.daiwacm.com mike.oh@kr.daiwacm.com sanghee.park@kr.daiwacm.com yumi.kim@kr.daiwacm.com jhlee@kr.daiwacm.com jihye.choi@kr.daiwacm.com yskwon@kr.daiwacm.com shannen.park@kr.daiwacm.com
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Taiwan Head of Taiwan Research; Strategy Banking/Diversified Financials Consumer/Retail IT/Technology Hardware (Communications Equipment); Software; Small/Medium Caps IT/Technology Hardware (Handsets and Components) IT/Technology Hardware (PC Hardware - Panels) IT/Technology Hardware (PC Components) Materials; Conglomerates Alex YANG Jerry YANG Yoshihiko KAWASHIMA Christine WANG Alex CHANG Chris LIN Jenny SHIH Albert HSU (886) 2 2345 3660 (886) 2 8788 1696 (886) 2 8780 5987 (886) 2 8788 1531 (886) 2 8788 1584 (886) 2 8788 1614 (886) 2 8780 1326 (886) 2 8786 2212 alex.yang@daiwacm-cathay.com.tw jerry.yang@daiwacm-cathay.com.tw y.kawashima@daiwacm-cathay.com.tw christine.wang@daiwacm-cathay.com.tw alex.chang@daiwacm-cathay.com.tw chris.lin@daiwacm-cathay.com.tw jenny.shih@daiwacm-cathay.com.tw albert.hsu@daiwacm-cathay.com.tw
India Deputy Head of Research; Strategy; Banking/Finance All Industries Automobiles and Components FMCG; Consumer Pharmaceuticals and Healthcare Punit SRIVASTAVA Fumio YOKOMICHI Ambrish MISHRA Percy PANTHAKI Kartik A. MEHTA (91) 22 6622 1013 (91) 22 6622 1003 (91) 22 6622 1060 (91) 22 6622 1063 (91) 22 6622 1012 punit.srivastava@in.daiwacm.com fumio.yokomichi@in.daiwacm.com ambrish.mishra@in.daiwacm.com percy.panthaki@in.daiwacm.com kartik.mehta@in.daiwacm.com
Singapore Head of Singapore Research Quantitative Research Quantitative Research Banking (ASEAN) Consumer; Food and Beverage; Small/Medium Cap (ASEAN) Tony DARWELL Josh CHERIAN Suzanne HO Srikanth VADLAMANI Pyari MENON (65) 6321 3050 (65) 6499 6549 (65) 6499 6545 (65) 6499 6570 (65) 6499 6566 (65) 6499 6548 (65) 6329 2102 (65) 6499 6543 (65) 6321 3085 tony.darwell@sg.daiwacm.com josh.cherian@sg.daiwacm.com suzanne.ho@sg.daiwacm.com srikanth.vadlamani@sg.daiwacm.com pyari.menon@sg.daiwacm.com adrian.loh@sg.daiwacm.com david.lum@sg.daiwacm.com ramakrishna.maruvada@sg.daiwacm.com amy.chew@sg.daiwacm.com
Regional Head of Oil and Gas; Oil and Gas (ASEAN and China); Capital Goods (Singapore) Adrian LOH Property and REITs Head of ASEAN & India Telecommunications; Telecommunications (ASEAN & India) Thematic Research David LUM Ramakrishna MARUVADA Amy CHEW
Australia Resources/Mining/Petroleum David BRENNAN (61) 3 9916 1323 david.brennan@au.daiwacm.com
The Philippines Head of the Philippines Research; Strategy; Capital Goods; Materials Economy; Consumer; Power and Utilities; Transportation Aviation Property; Banking; Transportation Port Rommel RODRIGO Alvin AROGO Danielo PICACHE (63) 2 813 7344 ext 302 rommel.rodrigo@dbpdaiwacm.com.ph (63) 2 813 7344 ext 301 alvin.arogo@dbpdaiwacm.com.ph
(63) 2 813 7344 ext 293 danielo.picache@dbpdaiwacm.com.ph
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3 January 2012
Daiwas Office
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(44) 20 7597 8000 (44) 20 7597 8600 (49) 69 717 080 (33) 1 56 262 200 (41) 22 818 7400 (39) 02 763 271 (7) 495 617 1960 (973) 17 534 452 (971) 47 090 401 (852) 2525 0121 (65) 6220 3666 (61) 3 9916 1300 (632) 813 7344 (49) 69 723 340 (33) 1 47 550 808 (41) 22 818 7441 (39) 02 763 27250 (7) 495 244 1977 (973) 17 535 113 (971) 43 230 332 (852) 2845 1621 (65) 6223 6198 (61) 3 9916 1330 (632) 848 0105
(886) 2 2723 9698 (886) 2 2345 3638 (82) 2 787 9100 (82) 2 787 9191
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The views about any and all of the subject securities and issuers expressed in this Research Report accurately reflect the personal views of the research analyst(s) primarily responsible for this report (or the views of the firm producing the report if no individual analysts[s] is named on the report); and no part of the compensation of such analyst(s) (or no part of the compensation of the firm if no individual analyst[s)] is named on the report) was, is, or will be directly or indirectly related to the specific recommendations or views contained in this Research Report. The following explains the rating system in the report as compared to relevant local indices, based on the beliefs of the author of the report. "1": the security could outperform the local index by more than 15% over the next six months. "2": the security is expected to outperform the local index by 5-15% over the next six months. "3": the security is expected to perform within 5% of the local index (better or worse) over the next six months. "4": the security is expected to underperform the local index by 5-15% over the next six months. "5": the security could underperform the local index by more than 15% over the next six months. Additional information may be available upon request. Japan - additional notification items pursuant to Article 37 of the Financial Instruments and Exchange Law (This Notification is only applicable where report is distributed by Daiwa Securities Capital Markets Co. Ltd.) If you decide to enter into a business arrangement with us based on the information described in materials presented along with this document, we ask you to pay close attention to the following items. In addition to the purchase price of a financial instrument, we will collect a trading commission* for each transaction as agreed beforehand with you. Since commissions may be included in the purchase price or may not be charged for certain transactions, we recommend that you confirm the commission for each transaction. In some cases, we may also charge a maximum of 2 million (including tax) per year as a standing proxy fee for our deposit of your securities, if you are a non-resident of Japan. For derivative and margin transactions etc., we may require collateral or margin requirements in accordance with an agreement made beforehand with you. Ordinarily in such cases, the amount of the transaction will be in excess of the required collateral or margin requirements. There is a risk that you will incur losses on your transactions due to changes in the market price of financial instruments based on fluctuations in interest rates, exchange rates, stock prices, real estate prices, commodity prices, and others. In addition, depending on the content of the transaction, the loss could exceed the amount of the collateral or margin requirements. There may be a difference between bid price etc. and ask price etc. of OTC derivatives handled by us. Before engaging in any trading, please thoroughly confirm accounting and tax treatments regarding your trading in financial instruments with such experts as certified public accountants. *The amount of the trading commission cannot be stated here in advance because it will be determined between our company and you based on current market conditions and the content of each transaction etc. When making an actual transaction, please be sure to carefully read the materials presented to you prior to the execution of agreement, and to take responsibility for your own decisions regarding the signing of the agreement with us. Corporate Name: Daiwa Securities Capital Markets Co. Ltd. Financial instruments firm: chief of Kanto Local Finance Bureau (Kin-sho) No.109 Memberships: Japan Securities Dealers Association, Financial Futures Association of Japan Japan Securities Investment Advisers Association Type II Financial Instruments Firms Association

ChinaOutlook120103 PDF (Daiwa)

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ChinaOutlook120103 PDF (Daiwa)

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China 3 January 2012

2012 Outlook for China

2012 Outlook for China

Note: closing share prices as at 19 December 2011

2012 Outlook for China

Back to 2008? We dont think so

Source: Daiwa; note: prices as of close on 19 December 2011

2012 Outlook for China

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2012 Outlook for China

What happened in 2008?

2012 Outlook for China: Back to 2008?

Aggregate demand (GDP)

2012 Outlook for China

Loss-making industrial enterprises

Amount of loss (LHS)

No of loss-making units (RHS)

The Lehman crisis

Where are we now?

A self-engineered domestic slowdown

2012 Outlook for China

Source: CEIC, Daiwa

2008 Real estate

Source: CEIC, Daiwa

Jan-Nov 2011 Infrastructure

2012 Outlook for China

Retail sales growth: nominal versus real

What will happen in 2012?

Nominal retail sales

Real retail sales

Exports: about to nosedive?

Jan-11 PMI: Export orders

2012 Outlook for China

GDP contribution by component

2012 Outlook for China

Ratios of property investment to GDP and FAI

1-year deposit rate, % p.a.

CPI inflation, % YoY

CPI inflation and one-year bank deposit rates

2012 Outlook for China

Source: CEIC, Daiwa forecasts

China: main macroeconomic indicators

2012 Outlook for China

China Market Strategy

2012 risk/reward outlook is good

80 60 40 20 0 10 20 30 40 50 60 70 (Weeks) Lehman collapse

MSCI China - Start date: 2 Nov 2007

MSCI China - Start date: 5 Nov 2010

What are valuations telling us?

May 04 Dec 05 20-M

Dec 05 - Nov 07 24-M

Nov 07 - Oct 08 - Aug 09 Oct 08 Aug 09 now 12-M 10-M 28-M

12-month forward PER

2012 Outlook for China

MSCI China Index: PER vs. MSCI Asia ex-Japan Index

12m fwd PER relative to MSCI ASJ

MSCI China Index

12-month trailing EPS

Relative to S&P 500

Relative to STOXX 600

12-month forward PER relative to long-term average

2012 Outlook for China